Stock prices are the result of buyers and sellers coming together in the market and deciding what they are willing to sell their holdings for or what they are willing to pay for shares in the desired companies.
Stock prices are the direct result of supply and demand for shares in the overall market.
This concept is not very helpful on its own, however, since what investors really want to know is which investments buyers will want in the near future.
Buyers generally set prices for stocks as the supply of stock is more stable than the demand. So, what are buyers of stock likely to want in the future?
Since the last recession (2007-2009), the Federal Reserve lowered interest rates and made lots of money available to investors. The hope was that this excess money would work its way into the overall economy and produce a stunning recovery.
As you all know now, the recovery was mediocre at best and much of the excess money found its way into assets, real estate, stocks, and bonds. Only those who owned such assets got wealthier as their prices were pushed up by loads of easy money. Those without assets got relatively poorer as they missed the great rise in asset prices. The rich got richer and the poor got poorer, as government policies dictated. So now you know why, from a technical perspective, stock prices have recovered so nicely since the last recession.
Fundamentally, stock prices are generally thought to be driven by corporate earnings per share. Even though there is a pretty good correlation between earnings per share and stock prices, correlation does not prove causation.
Nevertheless, those that espouse fundamental analysis, like Warren Buffett, put great stock in the health and direction of corporate earnings (per share). To be certain corporate earnings have surged since the last recession and are at all-time highs by many measures. This looks like further underpinning for current stock prices, but if you take a look under the hood (so to speak) you will find unsustainable adjustments being made to make earnings look better than otherwise might be the case.
Corporations have had a devil of a time growing their top line sales. The economy is growing, but only slowly. As such, most corporations are also growing slowly. To increase earnings with slow sales growth, corporate finance officers must find ways to reduce costs (cutting back on employment), reduce the number of shares outstanding (think share buy backs), perform cost saving mergers and divestitures, and utilize other shorter term strategies to keep everything humming.
The problem is that these measures are only short-term and carry long-run consequences that are not so pleasant. For example, worker productivity has fallen sharply since the last recession as cash flows have not gone to new plants and equipment, but instead have gone to the aforementioned financial engineering. Productivity is the engine that drives a rising standard of living over time and allows for families to have rising incomes. Median family income has been falling for eight or more years, a direct result of little to no gains in worker productivity.
In this world we have created, any notion of higher interest rates is viewed by the investment markets with terror. Cheap money and credit is the only thing propping up stock prices. As I have prescribed in numerous other columns, carefully maintain your investment liquidity so that you can move easily to cash in the event that the stock market starts a decided downtrend.
In a perfect world, we could transition from a monetary support investment market to one responding to improving fiscal policies and productivity would smoothly follow. In reality, the transition will probably be a rough ride, punctuated with numerous opportunities to participate in the brave new world that will hopefully follow the next presidential election.
