Six key factors affecting stock markets

Six key factors affecting stock markets
19 July 2012

STOCK markets are continuing their rocky ride: the Dow Jones Industrial Average rose 3.9% in June, but has fallen 2.5% in the second quarter of the year.

So what exactly is driving markets? cashy takes a look at six key factors that affect the direction of shares...

1. Central bank action

It seems that we are once again coming to a point where investors believe policymakers will step in to stave off a market panic that is, to some degree, self-fulfilling.

It looks very likely that the US Federal Reserve will announce another round of quantitative easing, or a second Operation Twist, and we have already seen the announcement of further liquidity support by the Bank of England. The European Central Bank will surely follow suit.

Analysts believe markets have already priced in most of the bad news, and there is so much caution amongst investors that we may see the ultimate ‘pain trade’ – risk assets rising sharply with central bank action as the trigger. Arguably this has already started in anticipation.

However, any increase in risk assets is likely to be a short-term trade, lasting weeks rather than months. It would be wise to remember that central bank stimulus will not resolve the longer-term issues, so any market bounce is very likely to be temporary in nature.

2. Volatility

The stock market is a volatile place to invest money. Daily, quarterly and annual moves can be dramatic, but it is this volatility that also generates the market returns investors experience.

There is a strong relationship between volatility and market performance. Volatility tends to decline as the stock market rises and increase as the stock market falls. When volatility increases, risk increases and returns decrease.

3. Interest rates

Regional and country economic factors, such as tax and interest rate policy, contribute to the directional change of the market.

For example, in many countries, the central bank sets the short-term interest rates for overnight borrowing by banks. When it changes the overnight rate, it can cause stock markets to react, sometimes violently.

4. Inflation

Changes in inflation trends influence the long-term stock market trends and volatility. Expanding price/earning (P/E) ratios tend to correspond to economic periods when inflation is either falling or is low and stable. This is when markets experience low volatility as they trend higher.

On the other hand, periods of falling P/E ratios tend to relate to rising or higher inflation periods when prices are more unstable. This tends to cause the stock market to decline and experience higher volatility.

5. World events

Industry and sector factors can also cause increased stock market volatility. For example, in the oil sector, a major weather storm in an important producing area can cause the price of oil to soar. The price of oil-related stocks will follow suit.

Some will benefit from the higher price of oil; others will be hurt. This increased volatility will affect overall markets as well as individual stocks.

6. Investor behaviour

The higher level of volatility that comes with bear markets has a direct impact on portfolios. It adds to the level of concern and worry on the part of investors as they watch the value of their portfolios move more violently and decrease in value. This causes irrational responses, which can increase investors’ losses.

Instead of heading for the exit, this is a prime opportunity to make investments that will potentially treble or more in value in the years to come.

As an investor’s portfolio of stocks declines, they should rebalance the weighting between stocks and bonds by buying more stocks as the price falls – allowing them to snap up shares at a lower price.

Pic credit: freedigitalphotos.net

What do you think is the key factor influencing your portfolio of shares just now? Tell cashy...

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Independent Financial Advisor
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