How Stock Prices Are
Stock prices are set by a combination of factors that no analyst can consistently understand or
predict. In general, economists say, they reflect the long-term earnings potential of companies. Investors are
attracted to stocks of companies they expect will earn substantial profits in the future; because many people wish
to buy stocks of such companies, prices of these stocks tend to rise. On the other hand, investors are reluctant to
purchase stocks of companies that face bleak earnings prospects; because fewer people wish to buy and more wish to
sell these stocks, prices fall.
When deciding whether to purchase or sell stocks, investors consider the general
business climate and outlook, the financial condition and prospects of the individual companies in which they are
considering investing, and whether stock prices relative to earnings already are above or below traditional norms.
Interest rate trends also influence stock prices significantly. Rising interest rates tend to depress stock prices
-- partly because they can foreshadow a general slowdown in economic activity and corporate profits, and partly
because they lure investors out of the stock market and into new issues of interest-bearing investments. Falling
rates, conversely, often lead to higher stock prices, both because they suggest easier borrowing and faster growth,
and because they make new interest-paying investments less attractive to investors.
A number of other factors complicate matters, however. For one thing, investors
generally buy stocks according to their expectations about the unpredictable future, not according to current
earnings. Expectations can be influenced by a variety of factors, many of them not necessarily rational or
justified. As a result, the short-term connection between prices and earnings can be tenuous.
Momentum also can distort stock prices. Rising prices typically woo more buyers into
the market, and the increased demand, in turn, drives prices higher still. Speculators often add to this upward
pressure by purchasing shares in the expectation they will be able to sell them later to other buyers at even
higher prices. Analysts describe a continuous rise in stock prices as a "bull" market. When speculative fever can
no longer be sustained, prices start to fall. If enough investors become worried about falling prices, they may
rush to sell their shares, adding to downward momentum. This is called a "bear" market.
During most of the 20th century, investors could earn more by investing in stocks than in other
types of financial investments -- provided they were willing to hold stocks for the long term.
In the short term, stock prices can be quite volatile, and impatient investors who
sell during periods of market decline easily can suffer losses. Peter Lynch, a renowned former manager of one of
America's largest stock mutual funds, noted in 1998, for instance, that U.S. stocks had lost value in 20 of the
previous 72 years.
According to Lynch, investors had
to wait 15 years after the stock market crash of 1929 to see their holdings regain their lost value. But people
who held their stock 20 years or more never lost money. In an analysis prepared for the U.S. Congress, the
federal government's General Accounting Office said that in the worst 20-year period since 1926, stock prices
increased 3 percent. In the best two decades, they rose 17 percent. By contrast, 20-year bond returns, a common
investment alternative to stocks, ranged between 1 percent and 10 percent.
Economists conclude from analyses like these that small investors fare best if they
can put their money into a diversified portfolio of stocks and hold them for the long term. But some investors are
willing to take risks in hopes of realizing bigger gains in the short term. And they have devised a number of
strategies for doing this.
Buying on Margin. Americans buy many things on credit, and stocks are no
exception. Investors who qualify can buy "on margin," making a stock purchase by paying 50 percent down and getting
a loan from their brokers for the remainder. If the price of stock bought on margin rises, these investors can sell
the stock, repay their brokers the borrowed amount plus interest and commissions, and still make a profit. If the
price goes down, however, brokers issue "margin calls," forcing the investors to pay additional money into their
accounts so that their loans still equal no more than half of the value of the stock. If an owner cannot produce
cash, the broker can sell some of the stock -- at the investor's loss -- to cover the debt.
Buying stock on margin is one kind of leveraged trading. It gives speculators --
traders willing to gamble on high-risk situations -- a chance to buy more shares. If their investment decisions are
correct, speculators can make a greater profit, but if they are misjudge the market, they can suffer bigger
losses.The Federal Reserve Board (frequently called"the Fed"), the U.S. government's central bank, sets the minimum
margin requirements specifying how much cash investors must put down when they buy stock. The Fed can vary margins.
If it wishes to stimulate the market, it can set low margins. If it sees a need to curb speculative enthusiasm, it
sets high margins. In some years, the Fed has required a full 100 percent payment, but for much of the time during
the last decades of the 20th century, it left the margin rate at 50 percent.
Selling Short. Another group of speculators are known as "short sellers." They
expect the price of a particular stock to fall, so they sell shares borrowed from their broker, hoping to profit by
replacing the stocks later with shares purchased on the open market at a lower price. While this approach offers an
opportunity for gains in a bear market, it is one of the riskiest ways to trade stocks. If a short seller guesses
wrong, the price of stock he or she has sold short may rise sharply, hitting the investor with large losses.
Options. Another way to leverage a relatively small outlay of cash is to buy
"call" options to purchase a particular stock later at close to its current price. If the market price rises, the
trader can exercise the option, making a big profit by then selling the shares at the higher market price
(alternatively, the trader can sell the option itself, which will have risen in value as the price of the
underlying stock has gone up). An option to sell stock, called a "put" option, works in the opposite direction,
committing the trader to sell a particular stock later at close to its current price. Much like short selling, put
options enable traders to profit from a declining market. But investors also can lose a lot of money if stock
prices do not move as they hope.