Factors Driving the Stock Market

Certainly, the business cycle does play a role. If you look at a chart of business cycle
fluctuations, superimposed on a stock market index, you will see that the stock
market generally and roughly follows. But generally and roughly are the
operative words, and that is the problem. If we consider some of the other
factors that move the stock market, besides the economy simply doing well and
growing, we easily see how complex it all becomes.

Interest Rates

If rates are likely to fall, stocks will be purchased and their prices will rise. But then there are also order quantities for Australian goods, which push
up stock prices when they increase - and of course, the other way round. But,
foreign orders depend partly on exchange rates, which also depend partly on the
interest rate and so on. Get the idea?

Investor Psychology

People may plunge into overheated markets, which are best left alone. And they panic and flee at exactly the best time to buy. Throughout economic history, we
have seen how markets overshoot and push prices up to levels that are not
justified by the real economy. And there is the converse, with people selling
out more than the economic situation justifies, simply because sentiment is
negative.

Political Factors and Sundry Disasters

An election, an assassination, terrorists attacks, epidemics of diseases and many other shocks that can appear tomorrow and be gone the next, or be around
for the next 20 years, can either make or lose you money. Note that these are
non-economic factors, meaning that the stock market reflects these too.

Additionally, some of these factors are inevitably driving share prices up, while others are pushing them down; sometimes the same variable can have
contradictory results when measured against other variables. So we have a
simultaneous and multifaceted interaction of forces working in all directions,
with extremely variable and varied intensities.

 Speculation

 Apart from the hard and soft factors described above, a fundamental reason for buying
stocks is, simply, that people think other buyers will pay more for them in the
future. This is the essence of speculation, and clearly has little to do with
the productive process at the heart of economic development.

Where Does This Leave Us?

Stock prices are driven by a very messy combination of economic, psychological and political
fundamentals. The result is that it is impossible to know in advance which
"fundamentals" and non-fundamentals will really prevail.

Despite all this, the trend can still be your friend. It is often possible to figure out
which factors will dominate over time, and, in particular, over a given period
of time. Likewise, some stocks, sectors and asset classes that look good, in
themselves, are really worth having. Predictions are possible, and it is not
all a game of chance. But, if you are looking for sure-fire indicators and
think that the business cycle and the stock exchange cycle are one and the
same, you will be in for a disappointment or worse.

The trick is to not try and figure out all the angles, but to determine what factors are likely
to count most over the time span of the investment. Despite the multitude of
influences that are potentially relevant, some are more important than others
at certain times, and for certain assets.

Putting It into Practice

If a popular president of a major economic power is assassinated, the markets are likely to
drop. For how long is another matter. Likewise, truly disastrous unemployment
figures must cause pessimism and eventually lead to stock sales.

Certain national and international trends can also be accurately forecasted to
continue. The demographic ascent of the aged, in the developed world, is most
definitely going to continue for the foreseeable future. This undoubtedly makes
some health- and age-related investments very promising. Some will still do
better than others, and individual schemes and assets will likely go bust along
the way, but the general economic reality of the "age of aging" will
be reflected in stock prices.

In a similar vein, climatic change doesn't seem to be going away. The fact that there is
money to be made from jumping on this bandwagon is incontrovertible. But,
exactly which investments will work and which will fail is difficult to
determine, and demonstrates the lack of a clear link between sound economics
and higher stock prices. There is a link, but there's no reliable correlation.

The same sorts of arguments apply to resources of various kinds. Nonetheless, this does not
stop the resource sector from being volatile. Even if water, for example, will
become a truly precious resource, over time, if you want a certain stream of
income, a government bond is a more suitable investment than infrastructural
projects in the Middle East.

Conclusion

If the economy is performing well, the stock market is likely to do the same. But, there is no
real reliable and consistent link that persists through all-market cycles in a
predictable pattern. There are simply too many forces at work and economic
reality is just one of them.

This does not mean that anything can happen, but it does mean that the financial sector and the real sector go hand in hand only part of the time, and
part of the way. This process is well summed-up by one expert as being similar
to a dog (the stock market) going for a walk with its master (the real
economy). The dog often runs this way and that, often in a rather unpredictable
matter. But it will come back to its master - until the next walk.

By Investopedia.com | 09.12.2011

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