What causes share prices to move?

If you want a nice academic discussion about the two principal views regarding why share prices fluctuate, go to:
http://insight.kellogg.northwestern.edu/index.php/Kellogg/article/agreeing_to_disagree/

One view is the "rational expectations" one, which opines that the market rationally analyses all news in relation to a company, and decides....

The other is the "differences of opinion" model, which believes that different market players come to different conclusions about a company and that it is the "clash of views" which eventually results in a particular level of demand for a company's shares (thus determining the price of the shares).

Unfortunately those models won't give you much real insight into the question of what causes fluctuations in share prices, because academic researchers usually take a fragmented and atomised view, divorced from real life.

In real life, the share price of a particular company shifts mainly because of reasons that are never discussed in the literature.

It is elementary economics that price is a function of demand versus supply. Naturally, if the number of shares of a company increases for any reason that could affect the share price too, but the share price usually moves because of fluctuations in demand - or, to be more precise, because of fluctuations in the numbers of people wanting to sell those shares versus the numbers of people wanting to buy those shares. Naturally, price plays a role here too, so the picture is a little complicated. But let's simplify it by saying that when an individual or mass of people with a large amount of money wants to buy shares in a particular company, the price of that company's shares is going to rise. Contrariwise, when a large number of people who hold a company's shares want to sell, the price is going to drop.

So what determines whether a lot of money chases or wants to exit a particular stock? Regretfully for our academicians above, both "rational expectations" and "differences of opinion" are second-order drivers of behaviour.

What are the first-order drivers of behaviour? This becomes easier to see if you look at it not from the point of view of the company in question but from the viewpoint of investors.

OK, so what drives investor strategy? It is essentially portfolio theory. As anyone who has ever professionally managed a portfolio will tell you, portfolio managers are seeking to balance two things: making as much money as possible on the one hand and, on the other hand, seeking to reduce risks - because investing in shares can produce profits, but you can also lose some or all your money if you have to sell at a lower price than you bought or if "your" company becomes bankrupt.

How does looking at a portfolio of investments enable one to achieve a balance between risk and profit? By deciding, in view of one's life circumstances and personal risk-appetite, what proportion of the portfolio should be put in relatively safe assets (let us say US Treasury Bonds) and what proportion should be put in riskier assets. Naturally, there is a gradation here, and some bonds are riskier than others (with junk bonds being among the riskiest) - on the other hand, some companies may be relatively stable while others are of course relatively volatile.

The rule of thumb is "no gain without pain" or "no risk, no fun". In other words, the safer options produce fewer returns on investment but you are less likely to lose your money - while the riskiest investments may produce the largest returns.

Having established the rough proportions to be allocated to safe versus exciting possibilities, how does a portfolio manager go about deciding where to invest the money that has been allocated to the exciting possibilities? The first thing that is looked at is country risk. So if China is viewed favourably (as it is at present, totally irrationally), then the portfolio manager is likely to want to put a relatiely large proportion of the money, with which s/he wants to play, in that country. On the other hand, if a particular country is looked at unfavourably, for example Zimbabwe(for rational or irrational reasons), then the portfolio manager is likely to want to exit that country (if indeed s/he has investments in that country to start with). The second thing at which any portfolio manager looks is the relative profitability of the different "sectors" in which investments can be made. Everyone knows that in boom times some industries flourish whereas those industries may do badly in times of recession - and that the case for other industries is vice versa.

It is only after the country and sector allocation has been decided that a professional manager decides which companies to look at within that sector and country.

In other words, the largest movements of capital take place primarily because of country and sector reasons, and only very secondarily because of reasons to do with particular companies.

Let us take an example. My son is the CEO of an Indian food company in Switzerland. His company is NOT publicly traded, so nothing will be gained or lost by using that as an example.

If I as a portfolio manager, had let us say 1 billion British pounds to put into exciting investments, the first question I would decide would be: in which countries to put how much money. This would be influenced, among other factors, by perceptions of political risk as well as currency risk. So let us say in current circumstances, that I decide to invest 25% in the USA, 25% in the EU, 10% in Switzerland, 10% in Japan, 10% in China, 10% in India and 10% in the Middle East.

Of my one billion, I now have only 100 million to invest in Switzerland.

Now, to what sectors am I going to allocate these 100 million? Let us imagine it is 40% to green industries, 10% to the manufacturing and machine tools sector, 10% to the financial services industries, 10% pharma, 10% to "fast moving consumer goods", 10% to tourism and 10% to "other" companies.

Now, of my 100 million, you can see that there is only 10 million that is available for all the "other companies"! Let us say that, for some reason, the portfolio manager decides to put 1 million into the leisure and entertainment sector, and for some reason decides to put 100,000 francs into my son's company.

Now let us see what happens if there are rumours of a political crisis or a natural disaster or some financial scandal with wide implications in China. Clearly the portfolio manager will decide to eliminate or reduce her/his China investments. Let us say s/he decides to reduce the China investments by 50%. Now s/he suddenly has 50 million to put somewhere else. Clearly, this money could be re-allocated according to the rest of the existing proportions between the areas concerned, or it could be disproportionately distributed. Naturally, as the world is so interlinked, the portfolio manager is going to think about which companies are going to be hit by the problems in China. S/he might conclude that most US companies are going to be hit as China is going to be forced to disinvest from the US - with a resulting hit to the US dollar. In addition, s/he might conclude that the EU is going to be hit because the European economy being highly manufacturing based and export-oriented, is so exposed to the Chinese market. So that leaves Switzerland, Japan, India and the Middle East. Let's say the portfolio manager decides to put 10 million each into the others, but 20 million into Switzerland (as it is considered a safe haven). You can see that even if this money was allocated in the exact proportions that the earlier money was put into Switzerland, suddenly 200,000 become available to be invested in my son's company - which should lead to an immediate rise in the price of his shares, even if nothing material has changed in his company.

That, in rather simplified terms, is the entire magic of the movement of the price of shares. "Rational expectations" affect the choice of a company within a sector. "Differences of opinion" do affect this to a certain extent but have a much larger impact on country allocation.

However, the above explanation depends on the traditional view of the world which has come into question in the last 20 odd years - and with the crisis, everything is up for grabs. With too much money being printed, country-performance was converging in an overall global bubble as was sector-performance over the 20 years preceding the crisis.

Now no one knows anything about how sectors will perform, let alone countries. The "best-peforming countries" (e.g. China) are notoriously opaque.

That is why everyone rushes around like sheep or like lemmings trying to follow where the share price appears to be moving, one finger in the air, the other hand's fingernails being bitten to the quick trying to get into markets which appear to be rising to get out of markets before they deflate.

It is not so much "difference of opinion" as "non-existence of opinion" (because no one understands what is happening). And it is certainly not "rational expectations".

If only all this had no effect on your life's savings, investing might be quite fun right now. Sphere: Related Content