At a very basic level, economists know that stock prices are determined by the supply of and demand for them, and stock prices adjust to keep supply and demand in balance (or equilibrium). At a deeper level, however, stock prices are set by a combination of factors that no analyst can consistently understand or predict. A number of economic models assert that stock prices reflect the long-term earning potential of companies (and, more specifically, the projected growth path of stock dividends). Investors are attracted to stocks of companies they expect will earn substantial profits in the future; because many people wish to buy stocks of such companies, prices of these stocks tend to rise. On the other hand, investors are reluctant to purchase stocks of companies that face bleak earnings prospects; because fewer people wish to buy and more wish to sell these stocks, prices fall.
When deciding whether to purchase or sell stocks, investors consider the general business climate and outlook, the financial condition and prospects of the individual companies in which they are considering investing, and whether stock prices relative to earnings already are above or below traditional norms. Interest rate trends also influence stock prices significantly. Rising interest rates tend to depress stock prices - partly because they can foreshadow a general slowdown in economic activity and corporate profits, and partly because they lure investors out of the stock market and into new issues of interest-bearing investments (i.e. bonds of both the corporate and Treasury varieties). Falling rates, conversely, often lead to higher stock prices, both because they suggest easier borrowing and faster growth and because they make new interest-paying investments less attractive to investors.
Other Factors That Determine Prices
A number of other factors complicate matters, however. For one thing, investors generally buy stocks according to their expectations about the unpredictable future, not according to current earnings. Expectations can be influenced by a variety of factors, many of them not necessarily rational or justified. As a result, the short-term connection between prices and earnings can be tenuous.
Momentum also can distort stock prices. Rising prices typically woo more buyers into the market, and the increased demand, in turn, drives prices higher still. Speculators often add to this upward pressure by purchasing shares in the expectation they will be able to sell them later to other buyers at even higher prices. Analysts describe a continuous rise in stock prices as a "bull" market. When speculative fever can no longer be sustained, prices start to fall. If enough investors become worried about falling prices, they may rush to sell their shares, adding to downward momentum. This is called a "bear" market.
This article is adapted from the book "Outline of the U.S. Economy" by Conte and Carr and has been adapted with permission from the U.S. Department of State.