When most investors refer to the term ‘market”, they mean the stock market according to some market index or indicator in general. The term “market” simply being the aggregate of all stock prices, is most conveniently measured by some index or average of stock prices.
A combined worth derived by aggregating various securities and/or any other kind of investment assets which expresses their summation in contrast to a base value from a certain date is called a market index. Market indexes trace the market’s variations with time as a representative of the whole stock market.
Investors determine timely variations in market values with the help of index values. Such as the Standard & Poor 500 index, taken as a benchmark by investors to balance their portfolio returns, is the combined index value of 500 large-cap U.S. stocks.
Market indexes give an estimate of the values of different stocks’ categories. An index going up by 1 percent means a stocks’ variety has a hike in its value by 1 percent as well as has become more likable to the investors.
Uses of market measures:
Investors use market measures to get a feel for the market and to know how all their stocks are doing in general.
Many investors like to invest in stocks if they are moving upwards; on the other hand, some investors feel encouraged to liquidate their holdings and invest in money market assets/funds.
Market measures’ historical records are helpful for determining whether the market is in a particular cycle and possibility for shedding light on what will happen.
Market measures are useful to investors for quickly assessing their overall portfolio performance. Because stocks tend to move either up or down, Indexes show the financial condition of industries where investors invest. For example, the Dow Jones Industrial Average (DJIA) has a dropping tendency for a month. In this scenario, an investor may assume, some of the companies included in it have a poor financial health. Keeping this in mind, the investor may reassess the portfolio s/he has as well as find other companies to invest. The rise and fall of the market generally indicate the investors how s/he is likely to do.
Market indexes are also used to calculate betas, (B) an important measure of risk. An individual securities returns are regressed on the market’s returns in order to estimate the securities beta or relative measure of systematic risk. Systematic, or market risk represents the instability that influences many industries, stocks, and assets. It affects the whole market and is difficult to predict. Diversification cannot help to reduce it, as it affects almost all types of assets and securities. Such as, the Great Recession was a kind of systematic risk which affected the overall market.
Beta is used to measure a stock’s instability in the market. It calculates the exposure of risk a particular stock or sector has in relation to the market. You can calculate your portfolio’s beta to know its systematic risk.
- A beta of 0 specifies that the portfolio is uncorrelated with the market.
- A beta less than 0 specifies that it moves in the opposite direction of the market.
- A beta between 0 and 1 specifies that it moves in the same direction of the market, with less volatility.
- A beta of 1 specifies that the portfolio moves in the same direction, have the same volatility and is sensitive to systematic risk.
- A beta greater than 1 specifies that the portfolio is very sensitive to systematic risk moving in the same direction of the market, with a higher magnitude,
Suppose the beta of an investor's portfolio is 2 in relation to a broad market index, such as the S&P 500. If the market increases by 2%, the portfolio will generally increase by 4%. Similarly, if the market decreases by 2%, the portfolio generally decreases by 4%.
Determinants of Stock Prices:
As a majority of investors focus on earning and P/E ratios, the P/E ratio or multiplier is the foundation to value the stock market using the fundamental analysis approach.
Expected earnings and the multiplier are used in the following equation-
E1= Expected earnings on the S & P 500 index.
Po/E1= The appropriate price earnings ratio or multiplier.
So, the determinants of stock prices are-
- The earnings Stream.
- The multiplier or P/E ratio.
1. The earnings Flow:
Estimating earnings flow for valuing the market is quite difficult. The item of interest is the earnings per share for a market index, or generally, tax deducted corporate profit.
Corporate profits are computed from corporate sales. Both are related to GDP. An overall analysis of the economy/ market involves estimating GDP, corporate sales, corporate earnings before taxes and corporate earnings after taxes, which can be lengthy and tiring. However, evidence supports the importance of this process as real (inflation-adjusted) earnings growth is correlated well with the real GDP growth for a long period of time.
2. The multiplier or P/E ratio:
The Multiplier used in the earnings estimate is the other half of the valuation framework. Investors sometimes mistakenly concentrate only on the earnings estimate ignoring the multiplier.
But the significant price changes in the market always is not mainly affected by earnings growth. Low interest rates may also lead to high P/E ratios causing much of the market’s price change.
Valuing the aggregate market is not easy because the market is always volatile. No one knows for sure how far the market is looking ahead and what the market will be willing to pay for a dollar of earnings. Furthermore, industry analysts are spectacularly optimistic when forecasting market earnings more than one quarter out, e.g., the earnings for next year for the S&P 500.
In spite of all the difficulties, to derive an estimate of the market value, an investor must analyze both factors that determine stock prices: corporate earnings and the multiplier.