Predicting share price movements is hard even for pro investors. There are complex interrelated external and internal factors affecting share prices.
Why investors must be aware of these external factors that affect share prices?
The reason is simple. These factors interact deeply with the market and the listed shares.
As a result, market tend to under-perform or over-perform due to influence from these factors.
Having said that, I would also like to add that its not easy to understand share market behaviour.
So what I am trying to say is, share market movements are itself unpredictable. To make the matter even complicated, there are external factors which also affects share prices.
Wait! Just don’t go away. There is a easy way out. Read this article through 🙂
It may take some time and practice to understand influence of external factors on share market. But, by just being aware of the fact that there are also external factors affecting share market, is half job done.
Simple awareness helps people to foresee trend reversals. But for sure it will not happen from day one.
Trick is to see and practice.
In this article we will read more about what to “see” and how to “practice”.
So first things first…
Why we invest money in shares?
We as investors invest in share market to make our money grow faster.
This is possible only if we invest our hard earned money smartly.
Investing smartly is possible only if we keep an eye on external and internal factors.
This way it will be possible to predict behaviour of share market.
#1) External factors affecting share prices in market
One important external factor that affects share market heavily from outside is commodity price.
Other important factors are like currency and risk free returns.
In this article we will see how these external factors affects share market performance in long and short term.
#1.1 Commodity Prices
Even small changes in price of crude oil effects common mans pocket.
Increase in crude price does not only make us pay more for fuel, but it also has a much wider impact.
All types of industry uses coal based fuel in some form or the other. Increase in oil prices directly increases the cost of production.
Expensive production rates means expensive end products. Means, consumers has to pay more.
This is what is the main cause of worry.
The price rise can have two repercussions. Either it is passed on to the consumer or company absorbs it by themselves.
In both the case companies financial results will be negatively effected.
Products getting costlier often leads to reduced sales.
Unprecedented increase in companies expenses leads to lower profit and profitability.
What does it mean to investors?
Both these repercussions will adversely affect the share price of the company.
Cotton is also one commodity that reasonably affects share market.
Textile industry, and retail sector is effected by fluctuations of cotton prices.
Gold price also has influence on share market and individual stock prices.
Share market and gold price is inversely related (generally).
If we see at historical price movements, it almost confirms that they are inversely related.
When share market is performing badly you will see gold prices soaring towards sky.
Not only on share market, gold effects anything which deals in paper currency.
We saw this few years back when US dollar was getting weaker. Nations Central Banks, financial institutions, investors were all buying gold like mad.
Weakening paper currency triggers demand for gold. Gold fever spreads like madness.
When people are buying gold they forget everything else, even the share market.
Gold price also directly influence on jewellery market in India and middle east.
Volatility in commodity market affects share prices.
Commodities that we use on our daily basis (like edible oil, crude oil, metals, grains, basic foods etc) have almost direct relation with share price reversals.
If price of essential commodities increase consistently, it decreases investors sentiments and leads to inflationary pressures.
In order to control inflation, governments increase bank interest rates. With increased interest rates (both on deposits and lending rates), borrowing becomes costlier.
Industrial sector greatly depend on bank loans to manage their cash flows.
With interest rates high, surely their operating margin will fall.
It means companies operating performance will go down. Immediately this will affect share prices of companies.
This is the reason why, governments across the world keeps a tight check on commodity prices.
Commodity price not only affects the companies, consumers but also the equity market as a whole.
#1.2 Currency Strength
All currencies of the world are not weighed equally. Like USD is more powerful than Indian Rupee.
So what is the problem? We saw the world this way since we are born…
USD, GBP, EURO, JYEN etc are currencies of superior nations and hence are stronger?
Lets assume for a moment that INR was doomed, hence it is weaker than USD, EURO etc.
But what happens if INR starts becoming stronger?
Majority of us will think that it is good for India? In long run yes, but in short term, it will negatively effect those Indian companies which do business with America, Europe, Australia etc.
Suppose an Indian company does $100 worth of business with USA. Today value of $100 is approx Rs.6,500. But if Rupee becomes stronger (1USD = Rs.45), the same $100 will be only Rs.4,500.
This is like a loss for the company.
Though India is not a major exporter to outside world, but almost all companies of IT sector and few in Pharma sector is dependent on business from America, Europe etc.
These companies will post less sales/PAT and hence their share price may fall.
Though the vice versa is also true. Rupee getting weaker means more sales/PAT for these companies.
This is only one side of the story.
There is an inherent problem with paper currency itself.
Share market was operational only after the paper currency became a legal tender of the world.
But the problem with paper currency is that it gets devalued with time.
The reason, there is no limit of how much paper notes a country can print. More notes in system, means weaker currency.
Remember the effect of hyperinflation on Zimbabwe’s local currency in 2015?
One USD was equivalent to 35,000 Trillion Zimbabwe’s dollars.
Why this happened? Because the country decided to print notes incessantly.
In such cases, people try to move away from paper currency.
Investors flee the stock market. Investors would not trade in anything which deals in paper currency.
To prevent this, central banks of the world keeps a tight check on the number of new currency notes issued in the system.
Nonetheless, new notes will get printed.
This ultimately leads to paper currency becoming weaker with time.
This happens with INR, USD, EURO, all.
There are times when confidence of investors on paper currency goes low. Recent example is demonetisation in India (Nov’16).
In such a situation people start parking their wealth in gold, silver, real estate and other hard assets (instead of paper currency).
As paper currency is getting devalued, people prefer hoarding gold. Gold price will at least appreciate with time. There is no fun in keeping paper currency in the savings account.
This kind of investors-pessimism has severe impact on performance of stock market and on individual share prices.
We also saw this recently during the US debt crisis and Euro Zone debt crisis.
It was due to lack of faith of investors in paper currency that gold price touched its peak.
The lack of trust in paper currency was so big that even big central banks of China and USA was hoarding gold like mad.
#1.3 Risk Free Interest Rates
Why we invest in riskier investment option like stocks?
The reason is to earn higher returns.
The returns expected from riskier investment option like stocks is Risk Free Returns + Risk Premium.
But what if we can earn higher returns from risk free investment options?
For sure we will prefer to park our money in risk free instruments.
Logic is, why to take risk (in options like stocks) if risk free rates are impressive.
In the past there has been incidence when people have found bank deposits more attractive than share market.
In such situations demand for stocks decreases.
If people are not investing in stocks, share market index will fall. Low participation in market negatively affects share market.
Higher risk free rate is bad for the companies as well.
This is because the loan becomes expensive for the companies. It means, higher expenses recorded in companies P&L accounts.
Same sales, higher expense leads to low profits and lower dividends to shareholders.
Share prices of such companies may also fall due to increased cost of debt.
#2) Internal factor affecting share prices
What factors are internal to stock market?
The performance of individual companies (business fundamentals) and sectors on a whole.
[Read more about fundamentally strong stocks]
Some examples are as below:
When companies bags big orders, its effect is immediately seen on its share price.
When company reports higher sales, profits, dividends etc, it share price rises.
Similarly bad news about the company negatively effects its share price.
There are also cases where the company is doing good business but its sector itself is weak, share prices of even such companies see fall.
Sometimes, even if the company or sector is strong, even then the share prices fall. This happens when there is negative sentiments prevailing in the market.
The best example is Brexit, 2008 USA’s debt crisis etc.
Recently we also saw a similar thing in India as well. In 2014, NDA came to power. Since then Sensex has jumped almost 13,000 points.
This does not mean that the underlying companies are doing equally good business. In fact sectors are IT, Steel, Pharma, Power, etc are in problem.
But just because of the positive sentiment created by the new regime, Sensex is playing bull.
How Investors can use these trend reversal signals to benefit from the stock market?
These trend reversal interrelation is very useful for investors. It may not give specific hints. It may not help us to time the market perfectly. But it can give us a general understanding of market movements.
You can then use this awareness to anticipate the trend reversals.
If we can closely watch commodity market, currency & debt market we can nearly predict trend reversals.
When it comes to investing in stocks, timing is important. If one can foresee a possible trend reversal, say one month before others, lots of money can be made.
In case price of commodity is increasing and there are inflationary pressures, we can safely assume that very soon this will trigger share market decline.
If you hear news of interest rates increase by government, it is inevitable that soon the share market is going to see dips.
I would like to comment here that people generally interpret these signs in a wrong way. In inflationary market, where commodities prices are increasing, it is not a sign where people shall start selling stocks.
Instead it is a sign that, the stock prices will fall. This is one excellent opportunity to buy some quality shares at discounted prices.
Inflation is not always bad. In fact controlled inflation is what triggers future growth.
In a market where instead of inflation there is deflation the growth prospects are negative. Hence, inflation is much better than deflation.
It is important for investors to know about external and internal factors affecting share market movements.
India is an emerging economy. Such market generally live under inflationary pressure.
Markets like India, China, Brazil, Russia etc are more likely to see trend-reversals in stock market.
Even minor changes in interest rate has noticeable effects on share market.
Understanding external factors affecting share market acts as a tool that investors must use to time the market.
This gives an investor an added advantage as not many people has this skill.
Internal factors affects share prices in a more direct way. These metrics are often tracked by people on regular basis.
A combination of, close observation of external and internal factors has potential to make one a better investor.