Why Do Stocks Go Up and Down?

What causes the P/E ratio to change?

A P/E ratio is not a fixed number, so it will vary based on numerous different factors. The introduction of a new product, good news of business growth or bad news of competition stepping up —all kinds of news can influence the P/E ratio and ultimately have an impact on how investors feel about buying shares, keeping them or selling them.

If good news comes along, investors are, generally speaking, more keen on buying shares and therefore they are willing to pay a higher P/E ratio, which causes share price to rise.

Getting back to our example of Best Coffee Shop

Let’s imagine a hypothetical news story that a great competitor to Best Coffee Shop, Starbucks, announces that it is going to open new stores right next door to every Best Coffee Shop location. Such news would be terrible for Best Coffee Shop, because chances are that a lot of consumers might choose the competitor over Best Coffee Shop. This could potentially result in making less than $20,000 in profit each year.

If you were interested in investing in Best Coffee Shop’s stock, after hearing such bad news, you probably wouldn’t be convinced in its ability to earn $20,000 in profit each year, and therefore, you probably wouldn’t be willing to pay 10 times earnings for that stock either.

It means that you would probably demand a lower P/E ratio to offset this new risk.

Let’s go with a P/E ratio of 5, which means that the share price of Best Coffee Shop would get cut in half. By paying just 5 times earnings, the buyer would earn a 20% return on their investment, which could be a high enough return to justify the extra risk.

To sum up – bad news usually causes buyers to be less enthusiastic about buying stocks. And the investors usually demand a lower P/E ratio, so the share price falls.

Now, let’s imagine a completely different scenario of how news influences a P/E ratio.

Say that Best Coffee Shop announces that it will start selling donuts and cookies. Many customers enjoy having coffee together with sweets like donuts and cookies, and such an announcement would be considered great news both by consumers and investors. Selling donuts and cookies would very likely lead Best Coffee Shop to earn $20,000 or even exceed that profit each year.

After hearing such exciting news, you probably would be very interested in investing in Best Coffee Shop’s stock, and you would probably be willing to pay more than 10 times the earnings. If we assume that you would be willing to pay 20 times the earnings which is a P/E ratio of 20, the price of one share of Best Coffee Shop would double.

Moreover, by paying 20 times the earnings, the buyer would be willing to accept just a 5% return on their investment.

But since Best Coffee Shop has the potential to earn a much higher profit, the value of the business and the share price would most likely grow over time. Buyers would also be more willing to pay a higher P/E ratio.

Generally, when exciting news appears, investors are more excited to buy stock, so they are more eager to pay a higher P/E ratio and pay a higher share price.

As we just learned in both hypothetical scenarios, the Best Coffee Shop was the very same business with profit of $20,000 a year, however the news that broke in the media influenced buyers’ and sellers’ attitudes and their perception of the future profit of Best Coffee Shop, and this caused the P/E ratio and the share price to move up and down in response.

Why does a stock price go up and down?

We just learned that news can impact the price of shares so it can both rise or drop significantly. But you may wonder, what happens on days when there is no news? Well, most stocks go up or down just a bit.

Why does this happen?

On the one hand the investors as a group can feel somewhat more optimistic about a company’s future and it makes them willing to pay a higher P/E ratio to own the stock, and so the stock price rises a bit. On the other hand, the investors as a group may feel more pessimistic about a company’s future, so they demand a lower P/E ratio to own the stock.

The attitude towards being interested in purchasing or selling shares at a certain P/E ratio influences the price of shares on a daily basis. This is the most common reason for the stock to move up and down every day.

When thinking of the stock market and how the price fluctuates, you should know about three crucial factors at play when investors buy and sell shares:

• The Ask Price
• The Bid Price
• The Spread

To get a grasp on how it really works, think of the stock market as a live, ongoing auction. Let’s make an example that a stock is trading for $100 per share – some shareholders are a bit pessimistic about the company’s financial potential in the future and they decide to sell their stocks at any price over $100.10 per share, which is the current market price. This would be the ask price, which is the lowest price that a seller will accept for a security.

Moving forward, let’s say that there are also some investors who are eager to buy the stock, however they are not willing to pay $100 per share. Instead, they would buy it only if the price was $99.90 per share or even less than that. This would be the bid price, which is the highest price a buyer would pay for a security.

In this very scenario, the ask price is $100.10 per share and the bid price is $99.90, so the difference between those two numbers is $0.20, which is called the spread. The spread is the difference between the ask price and the bid price.

Now, imagine that some of the existing shareholders are more interested in selling than the potential buyers are in buying. One of the sellers makes a decision to accept the $99.90 bid price, which is the very last price that a trade took place. In this case, the eagerness of the sellers outweighed the eagerness of the buyers, which resulted in the stock price falling.

On the other hand, if potential buyers are more eager to buy than existing shareholders are to sell, the price could rise to the point that existing shareholders are willing to sell their shares.

To wrap it up, investors’ optimism causes the share price to rise and their pessimism causes the share price to fall, which is why the stocks rise and fall on any given day.

Why does the stock market go up and down everyday?

Like the stock price, the stock market also moves up and down based on how optimistic or pessimistic investors feel on any given day. Therefore, the stock market also has a P/E ratio that changes a bit every day.

Let’s take a look at the chart which shows the P/E ratio of the S&P 500 from January 1st in 2010 through January 1st in 2019.

In January 2010, the P/E ratio of the S&P 500 was a bit more than 20 and it gradually fell over the next 20 months before it bottomed out around 13 in late 2011. Since then, it steadily expanded until it finally reached 25 in January 2018. Then it declined again, this time to 19. The number bounced around due to the attitude of the group of investors and how they felt about future profit of the S&P 500 companies. It caused slight changes in the P/E ratio as well as the share prices.

All of these changes are usually not related to any horrific or exciting event. But every now and then, a major event takes place, like the world pandemic starting in early 2020, which caused global panic within various stock markets, including the S&P 500 resulting in a 25% drop between mid February and mid March 2020.

Just like that, as quickly as the fall happened, when the U.S. Government announced that it would help the financial hardship of its citizens, the S&P 500 rose 9% in a single day in response to this promising news.

All of these examples show that the stock market rises and falls according to the investors’ beliefs in companies having the ability or inability to make a profit in the future.

Why does a stock go up or down over the long-term?

In the long term, the share price follows changes in earnings. When earnings go up, the stock price goes up. On the other hand, when earnings go down, then the stock price goes down.

However, in the short term, a stock can move up or down for any number of reasons.

Imagine that Best Coffee Shop is always valued at exactly 10 times earnings, it also succeeds in opening up one new store every year, and each of these stores produce $20,000 in new earnings. The price for one share of Best Coffee Shop in one year would be $10. The price of one share will be $20 in year 2.

Let’s look at what the price of one share will be every single year.

As you can see, the price of one share of Best Coffee Shop went from $10 in one year to $100 in year 10. If you actually bought it in year one and held it until year 10, you would have earned 10 times your initial investment.

This is exactly the reason why a stock goes up over the long term —because the share price follows changes in earnings. When earnings go up, the stock price goes up and when earnings go down, the stock price goes down. Still, we need to take into consideration that the P/E ratio is not a fixed number and it changes based on investors’ attitudes towards a company’s financial future.

How often does the stock market go up?

It used to be common conviction that the stock market goes up around 10% annually, however you wouldn’t be able to actually see that when looking only at daily stock price movements, because it can rise about 52% of the time and fall 48% of the time. You just can’t tell.

On the other hand, when you look at the S&P 500 over a longer period of time, like a month, the S&P 500 goes up 61% of the time and goes down 39% of the time. Over a 6-month period, it goes up 66% of the time, and over a 1-year period, it goes up 69% of the time.

So let’s take a look at even longer periods.

As you can see the S&P 500 produced a positive return 100% of the time over every 20-year holding period. And also, as the holding period increases, the odds of achieving a positive return increase.

Now you know why the stock market and stock prices move, be sure to read the next part where we explain why earnings go up and the factors drive them up.