I was motivated to major in Economics because I wanted to understand human behavior and how the world works. Especially things that don’t make any sense. It’s hard to find a better example than the stock market. There are hundreds of publications and TV networks and commentators that try to make sense of something that really seems to makes no sense.
But it actually does make sense. It’s just a kind of sense that’s difficult to accept especially if you’ve invested your retirement into the market.
Let’s start with things that are often cited as reasons for stocks going up or down:
- Company earnings
- News stories
- P/E ratio or other numerics
- New product introduction
I could go on. But none of these directly causes a stock to go up or down. It’s easy to prove this by picking a company and looking at historical price moves based on one of the items above. It turns out that “undervalued” stocks sometimes go up and sometimes go down. Stocks rise or fall after great earnings. Layoffs have unpredictable effects. Positive or negative news can lead to an opposite price move.
With a contrary move in a stock price, you’ll hear pundits try to explain it away, but the truth is that you can’t predict it and you can’t explain it.
The simple truth on what causes a stock to be at a specific price at a specific moment is simply what price a buyer is willing to pay and a seller is willing to accept to part with their shares. If the number of shares for sale matches those that people want to buy, it’s likely the share price will be fairly stable. But it’s almost always out of balance and that’s what causes the price to move.
This is very uncomfortable to think that a stock price can move just because of the independent buying and selling decisions of millions of people. We honestly have no idea or no way of knowing what drives all these decisions.
A company can have great earnings and people can read about it and decide to buy. If they place buy orders and not enough shares are available to sell at the going rate then the price goes up to entice sellers to part with their shares. The earnings reports didn’t cause the stock to go up. It influenced people’s decisions and it tilted in favor of a higher price.
It’s a subtle but very important difference. Imagine the same earnings news is mostly ignored and instead people focus on a popular twitter posting negative information about the company. Then the stock price goes down because there are not enough buyers. There’s no direct connection between the news and the price move. If there was, it would be predictable.
On top of all the other factors, there are some really huge ones that can’t be ignored. There is automated trading that happens when stocks hit certain prices. There are mutual funds that have to buy and sell on a given day to balance out their portfolios. In this case, nothing in the news is driving these purchases.
And that’s what makes stocks go up or down.