What Really Drives the Stock Market?

The recent stock market volatility has caught many share market investors and traders off guard. After such a stellar run from Mar 09 the current headwinds are creating great confusion for the average person. Investors and traders are questioning whether the recent stock market volatility is just a temporary pullback in the bull market or something more sinister. Over the long term financial markets are driven by the underlying fundamentals of the individual companies that make up the market and the economy in which these companies operate. In the short term however, financial markets are driven by sentiment. Market sentiment is the collective views of all market participants at a given point in time. Sentiment never remains static, it is always in a constant state of change. As the future economic outlook changes, so to will market sentiment. Having a basic understanding of economic news and more importantly the likely impact on market sentiment is essential to succeed in the stock market Current Market Sentiment Prior to April 2010 market sentiment was nothing short of bullish. Most world indices have rallied from the depths of early 2009 to achieve stellar gains in little over twelve months. During this period, most of the government and mainstream media commentary was literally ‘talking up’ the economic outlook. Anyone brave enough to talk of a double-dip recession or depression was quickly challenged by government officials, economists and various sections of the press. In an attempt to jumpstart the economies of the world, most major economic data was painted in a positive light, regardless of whether it was encouraging or not. Sentiment in most financial markets was positive and this helped to fuel one of the greatest stock market rallies of all time. Any fears of a slow down in China or European debt problems were quickly brushed aside. But since April market sentiment has changed. Government officials, economists and mainstream media outlets are talking of the real possibility of a double-dip recession in the US economy. So what’s caused the change? Strangely most of the factors currently feeding the renewed bout of negative sentiment were already with us months ago. In the US fears of a double-dip recession are again beginning to surface. Unemployment remains stubbornly high unemployment and there seems little hope of any immediate improvement for the 8 million people who lost jobs. US housing is a basket case. Foreclosures remain high, home sales are none existent, and values continue to decline. All this is keeping consumer and business confidence fragile. And the Government stimulus package is basically all but finished with only the massive debt remaining for future generations to repay. In China, government authorities are trying to rein in a housing price boom through tighter credit controls on construction. Solid domestic demand is tempered by slow demand for Chinese products outside of China and to top things off there are currency tensions between China and the US. In Japan CPI remains ‘locked’ in a deflationary spiral and whilst falling prices may sound appealing, falling prices impede economic growth as companies and households tend to postpone spending. In Europe the big issue is debt, in particular the lingering fears of Sovereign debt and its impact on the banking sector. Question marks remain over the high levels of debt in Greece, Spain, Ireland, Italy, Portugal and Britain. Most of these factors are not new. What has changed is the way the financial markets are choosing to view them. How can this help your investment or trading decisions? A keen trader or investor can greatly improve their chances of success by being on the right side of the market. Being on the right side of the market requires the ability to ‘read’ the prevailing sentiment in the market. Although this is far from an exact science, being aware of the prevailing market sentiment provides you with an idea of whether you should be taking long or short positions or whether you should be out of the market entirely. So what guidelines can you generally apply to the expected market reaction to an economic data release? Although markets are forward-looking in nature, the release of economic data often has the following influence on markets: Bullish stock market sentiment Positive Data Result – the market rallies, Negative Data Result – the market generally shrugs off the result and continues to move higher, but at a slower pace. Bearish stock market sentiment Negative Data Result – the market declines Positive Data Result – the market generally disregards the result and continues to decline, but at a slower pace. Churning stock market (Neutral Sentiment) Positive and negative data results – the market generally continues to search for direction (i.e. remains locked in a trading range). It’s important to understand that market professions often influence the way news and issues are reported in the media. By doing so, you can gain a valuable insight into the direction market ‘heavy weights’ are intending to move the market.