How These 5 Factors Affect the Stock Market

Many factors could have positive or negative impact on the general market.  This post outlines the following five important elements might move the market in significant way.

1. Corporate earnings

          Generally speaking, the stock price is determined by market value per share (often referred to as the P/E ratio) and earnings per share (often referred to as the EPS), especially in an efficient market.  Given the same level of P/E ratio, the higher the EPS is, the higher the stock price will appreciate.  A soaring P/E means that the stock has higher estimates of earnings expected in the next four quarters. 

Different industries have different levels of P/E ratio.  For example, tech companies tend to have higher P/E ratios, since investors have higher growth expectations from that industry.  In the past few years, since the recovery of the financial crisis, the rising P/E ratio has been one of the preeminent factors that have driven the US stock market rally.  However, an extended rising of the stock market might not be sustainable if the earnings do not match the same pace. This is because the shares of stock become pricy and won’t appeal to investors any more.

In bull markets, the P/E ratio tends to be higher than that in bear markets.  The P/E ratio ranges from 20-25 in bull markets historically. 

2. Federal Reserve Influence

          The direction that the Federal Reserve moves affects interest rates.  If interest rates are hiked, the cost for corporations to function will go higher too.  It will eventually erode corporate profit, and further decrease profit margins.  The EPS will drop accordingly, which will have an inverse effect on the stock market, assuming the P/E ratio or valuation stays at a similar level.

          In recent years, especially after the financial crisis of 2007-08, the fiscal and monetary policy from major countries had a broad and deep effect on the financial marketplace. By adjusting interest rates, the central banks could adequately slow, or speed up growth, within that country. This is how monetary policy plays a role in our economy.

          On the other hand, the fiscal policy is another tool for governments to make an impact on the financial market.  By implementing a fiscal policy, our government either expands or cuts back spending. The current fiscal policy aims at abating unemployment rates and appreciating asset prices.

Technically, governments are able to alter investment inflows and outflows among countries by easing or hiking interest rates. This also influences the amount of money available on the open market. The money flow in a country has a positive effect on the strength of a country's economy, wealth, and currency. Generally speaking, if a large amount of money is leaving a country, this country's economy and currency is weakened.

On the other hand, countries that predominantly export either goods or service, reap the profits from exports flooding into the country’s revenue base. Therefore, this money can be utilized for reinvestment and stimulating the financial markets and economic bodies.

3. The World Situation

Economic globalization is the growing economic interconnection of economic activities among countries by the accelerated increase in exchanges of goods, services, capital, information, etc.  In the meanwhile, it creates an adjoining interdependency, and intensifies competitiveness among regions and countries. Of course, it ultimately results in much higher productivity and more optimized resource allocation.

          On the other hand, if something disastrous, such as a large scale earthquake, terrorism, or tsunami happened in any corner in the world, it might impact the entire equity markets conversely. 

4. Investor Sentiment and Confidence

          When the overall investor sentiment and confidence becomes euphoric, you must be cautious because when everybody chases the market and stocks, there is not much liquidity left to boost share prices and the market level.

          On July 3, 2009, in a CNBC interview, Warren Buffet once said, “In investing, pessimism is your friend, euphoria is the enemy”.

History has shown that when the herd moves in one direction, it may be time to consider going the other way. Therefore, the sentiment detection in the stock market becomes increasingly crucial in our financial life. We are going to discuss some technical indicators which might be helpful to investors and traders.

5. Supply of liquidity

Supply of liquidity, QE, is another key factor that impacts the movement of the current stock market.

Quantitative Easing (QE) has played increasingly more important roles in the financial marketplace and economic systems. It was first introduced by Japan. Nowadays, it has been used by central banks to inject liquidity into the economy and stimulate the economy. The Federal Reserve Bank first launched QE 1 in November 2008, and ended it in March 2010.  Then QE2 lasted from November 2010, to June 2011. 

QE3 was announced on September 13, 2012 to purchase $40 billion worth of mortgage-backed securities per month. On September 21, 2011, the Federal Open Market Committee (FOMC) announced the implementation of Operation Twist. Lastly, on December 12, 2012 the QE4 was declared to increase the bond purchasing amount from $40 billion to $85 billion. The Fed pledged to maintain the QE program until the labor market was improved significantly (6.5% unemployment rate as a benchmark). Thus, it is called QE Infinity.  The market had the best performance of the last 65 years since the QE was implemented in late 2008.

Supply and demand rule is applicable to the stock market too.  When the QE ends, it means the demand for securities decreases too. The price of equities is expected to drop assuming the P/E ratio remains at similar levels.

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