Expert: Mark Hodge - 9/17/2008

Question
Hello,

thank you for taking on my questions. I have always wondered about some things on how the stock market really works.

To begin with this is what I know or think I know, please tell me if this is wrong.

The price of the stocks on the open market (second market) is changing due to what people offer and are willing to buy the stocks for. If for example person A puts out an order on 10$ and there is a person willing to sell for 10$ then there is a deal and the stock price now changes to 10$.

And later on person A has order out for 11$ and B has sell order of 11$ there is a deal and the stock price goes up to 11$.

So from my point of view the power of changing stock prices is in the hands of the people trading, the market.

So far so good. Now to my questions.

These days the global economy seems to have some trouble and worries. Thinking of the bank that recently got bankruptcy and other things that is currently making the stock market fall.

But what actually makes it fall due to this? I mean if there is the people that trades that is in the power to change the stock price. Why are they worried? What is there to worry about?

If you for example have a good solid company stock where the risk of that company becoming bankruptcy is very very low. Why are you suddenly wanting to get rid of your shares cheaper?

Hypothetically from what I see if people just would ignore the worries and continue trading at the same prices, the stock price would not fall. Am I wrong?

So basically what are there to worry about really? Is the stock worth less, who says?! What is making it worth less? I don't really realize what people suddenly are so worried about unless the company itself has the risk of going bankruptcy and the stocks are worthless because of that?

My second question: Is there something else than the trading of the stock that can affect the stock price? I mean can the company give out a report that now they have earned X amount of money and then the stock price automatically gets adjusted according to that? Without people having to trade the price up to that level?

If that is the case then it could explain my question number 1.

Thanks a lot if you could give me some light on this.
/Christer

Answer
Hello Christer,

Welcome to the wonderful world of trading and investing, where many times things just don't make sense!

You have some good observations and yes, when you get a quote on a stock price, we are seeing the last price that the stock exchanged hands at. When you have a strong company that is expected to go up, then theoretically it would make sense that the stock would continue to remain strong, and for price to not fall. However, trading and investing is entirely based on supply and demand, AND fear and greed. A stock might be in demand because of good news and expectations, but if investors are fearful of a decline in the stock's value (even if it's just temporarily), price will go down because there are not as many traders willing to buy at a higher price, and there are more people willing to sell.

Remember that fear and greed rules the market regardless of what SHOULD happen, and the relationship between an investor and a stock's price is going to be based on FUTURE expectations. Consider this, if you owned a stock and the price was $12, but you didn't expect it to rise much in the future, you're probably going to sell. The stock might be worth $12, but why hold it if you could put your money in stocks that could be worth more in the future. In a situation like last week, let's say you bought a stock at $15, and it is currently trading at $20. If the overall market is struggling you have 2 decisions that you can make:

1) continue to hold because you know that the stock is solid and you hope that the overall market doesn't trickle into this stock's value.

2) sell at the current price for a gauranteed profit, and consider buying it back lower on a dip. Now you've locked in a profit and have cash to use to buy this stock, or another in the future.

Notice that example #1 plays on GREED, and example #2 plays on FEAR. If a stock is trading at $20 this is what it is worth...bottom-line. There are NO guarantees on whether the stock will go up OR down, so it is often emotions that impact when an investor gets in or out.

Now obviously there is so much more to investing and a company's value, but supply, demand, fear, and greed will impact a stock's value more than an other factors. It might sound strange but this is how Wall Street works. Otherwise good companies that have good  valuation, growth, and earnings would never go down because you'd know EXACTLY what it should be worth.

I think that I've addressed both of your questions, but to clarify question 2, a stock doesn't automatically get priced differently because of an announcement. You'd think that stocks would always move up on good news, and down on bad news, but because investors and traders take positions based on future expectations (not current)ones, it might be that the news was GREAT, but traders get out because that was what they expected and now want to sell, essentially pushing the stock lower on good news.

Happy Trading/Investing!