What causes a company’s stock price to rise? Although there are several factors, one of the most important is revenue and income growth. For a company’s shares to rise in value, it must continually sell more goods and/or services. In other words, revenue must increase. Revenue is the total amount of money received by a company for goods sold and/or services provided for a specific time period. Companies listed on the US. stock exchange are required by the Securities and Exchange Commission (SEC) to re-port quarterly and annual earnings. If a company’s revenue increases from one quarter to the next, this is viewed positively by investors and will most likely be reflected in a higher stock price.
What is troubling in the current economic environment is that stock prices are increasing as revenue and earnings decline. The Wall Street Journal (WSJ) (8/16/16, C4) reported that the earnings of companies in the S&P 500 have been falling for the last eighteen months. This trend is likely to continue. Ac-cording to the WSJ (9/3/16) “Third-quarter profits … are projected to contract by 2.1%.”
There are several factors that suggest revenue for many companies will not rise in the coming quarter. First, government reports note a decrease in inventory investment. In other words, companies are not building up inventories to the same extent as in previous quarters. Companies reduce inventory lev-els when consumers are not expected to buy at past levels. This reduction is true not only in the manufacturing sector but in the housing sector as well. Less inventory available to purchase results in a decrease in the number of items sold resulting in lower revenue and net income.
A second factor that could adversely affect stocks is the current political situation. The market does not like uncertainty. As the elections approach and there is a greater distinction between the economic plans of the candidates, the ambiguity of the results could affect the stock market.
And yet, stock prices are hitting new highs. A WSJ article (8/15/16) suggests the market is overvalued. According to one long -term valuation indicator, the price/earnings ratio of companies in the S&P 500 index stands at 27.1. This is well above its long-term average of about 16.
So what is driving up the market? It has been suggested that investors seeking higher yields are mov-ing their money from lower-yielding investments (e.g. bonds, CDs) into the stock market. This factor could explain the highly volatile week of Sept. 12. Indications that the Federal Reserve might raise interest rates at its September meeting caused a triple-digit stock decline. The following day when a Fed member suggested rates would stay the same, the market rose nearly erasing the loss of the prior day.
Why does a rise in interest rates significantly and negatively affect the stock market? If bond yields rise many investors will sell their stock holdings to buy bonds, putting downward pressure on share price. Bonds are less risky than stocks and therefore preferred by risk-averse investors.
According to the WSJ, the projection that consumer spending would grow and the market would be stronger in the second half of the year also sent stocks soaring. However, the most recent WSJ projection is that real consumption growth for the third quarter will come in around 2.7%, down sharply from the second quarter’s 4.3% rate.
What should an investor do in these uncertain times? Like most investors, I only know 2 things with any certainty: The market will go up and the market will go down. No one can predict what will happen with stocks. However, whatever action you take should be based on sound reasoning and research.