Reality of stock markets includes volatility

Equities investors naturally want their investments to continually rise in price. But in reality, stock markets are always going up and down.

Stock markets are never stable or flat because there are so many players, says Adelaide Kim, vice-president and portfolio manager at Mackenzie Investments.

“Because it’s made up of various participants, everyone will have their beliefs, assumptions and estimates on the companies that make up the market,” added Kim.

The stock market comprises the prices of publicly traded companies. The price of a stock reflects the future expected value a company will provide to its shareholders, whether as earnings potential or profitability, says Jeet Dhillon, vice-president and senior portfolio manager at TD Wealth Private Investment Counsel.

Supply and demand

One reason markets fluctuate is because of the change in supply and demand for a particular stock. More people buying a stock would cause its price to rise. Conversely, more people selling a stock would cause its price to drop.

The price of a stock should reflect the future earnings outlook for that company, says Dhillon. Investors often consider more than one factor when trying to forecast that outlook.

Many factors can lead investors to have “a good reaction or a bad reaction toward the outlook for a particular stock, which can lead to volatility in the market, good or bad,” she added.

For example, uncertainty about trade agreements can make investors nervous, causing them to sell a stock or pay a lower price for it. Related current events (which can be as diverse as weather events or an election) can also cause uncertainty. That’s often because investors are reacting to what is reported in the media as opposed to looking at the business fundamentals of a company (the qualitative and quantitative information that contributes to a company’s financial valuation).

Major factors that affect the market

Changes in individual companies

News about a company or changes in its performance can affect its stock price. Specifically, news or press releases on earnings or profits, or even analysts’ estimates on earnings or forecasts, can affect the stock market, says Sam Febbraro, executive vice-president at Investment Planning Counsel. Such news can include:

• launch of a new product or a product recall;
• securing (or not securing) a large contract or deal;
• a change of management;
• a takeover or merger in the industry; and
• security breaches or questions about a company’s data integrity.

One company’s good or bad news can also affect others in the same sector.

“Look back to the 2007-2008 financial crisis and what happened with the financial sector in the U.S.,” says Dhillon. “By association, a lot of good companies that were financial institutions saw a downward trend in their stock price by association, not necessarily because they were having troubles of their own.”

Geopolitical events

Geopolitical events can make investors nervous or buoy their optimism, likely causing stock markets to drop and rise, respectively. These events can include uncertain (or signing of) trade agreements, news of higher (or lower) corporate taxes, and acts of terrorism (or news of a peace agreement).

In the case of events perceived as negative, the resulting uncertainty “can cause a lot of anxiety,” says Dhillon. “People will start feeling nervous about these events and wonder, ‘Is it a good time to take some of that profit and not be so involved in companies that may be affected?’”

Conversely, events perceived as positive can be good for businesses since they might invest more, make more sales or incur fewer costs (from tax cuts, for example).

Commodities

Fluctuating prices for commodities such as oil, gas, timber, gold, silver, copper and lead can affect the earnings of companies that use, sell or process those commodities, and therefore markets as a whole. For example, the rise and fall of oil prices can affect stock markets because of its impact on oil and energy companies, says Kim.

Interest rates

Central banks, including the Bank of Canada, lower and raise interest rates to stimulate, stabilize or cool down the economy.

Higher interest rates mean people and companies have to pay more to borrow money, since they’ll have to pay higher interest rates on their debt.

This can make it tougher for companies, since “they might not have that much money left to invest in other projects to grow the company, and it can cut into their profits,” says Dhillon. “So, they might cut back on other spending. That can lead to a reduction in their overall prospects for the future or their earning potential.”

Limiting the growth of companies through higher interest rates can cause stock markets to drop. On the other hand, lowering interest rates can cause stock markets to rise based on the assumption businesses will increase their spending.

Why volatility can be good

Overall, though, volatility in the markets is a good thing because it reflects changes in the market assumptions, says Kim.

“Markets should be made up of investors with different assumptions and estimates. Otherwise, it ceases to function if everyone were to think the same way. There has to be differences of opinion to allow for a trade to happen.”