18 May 2020

The determinants of stock market prices

By DICC Institute

In theory, the value of a security (stock or bond) is measured by the present value of the future total return that can be expected.

That is to say that we reduce to a value today, the estimated value of the dividends or coupons that we will receive during the entire holding period as well as the gain or loss on disposal that will be made for resale. This involves updating future returns and analyzing the factors that may affect the returns on the security.

There are general and title specific factors.

General factors

They are numerous, not always easy to predict, isolate or analyze. But we can identify a few that clearly have an impact on the stock market:

  • The economic and political environment: strong growth, particularly in the United States, and a calm political situation are all factors of stability and demand on the stock markets. For example, if there is growth, corporate profits are assumed to increase, which has a ripple effect on stock prices.
  • Interest rates. Short rates, set by central banks (up to fight inflation, down to revive growth), have an impact on long rates, which determine the price at which companies can borrow.  When rates go up, the price of fixed rate bonds goes down and vice versa. Why? Because, in the event of a rise in rates, old bonds, which serve a lower interest, become less attractive, and find takers on the market only on the condition that their price drops.

As rising rates make bonds cheaper, holders of stocks can arbitrate in favor of bonds, sell their shares, the price of which, therefore, drops. But as soon as the price of the shares drops too much, they become more profitable, which again encourages the purchases of shares and causes their price to rise.

  • Price developments can have contradictory effects. If households anticipate higher prices, they may tend to consume more, fearful of future price increases, and therefore save less. Conversely, if they wish to maintain the value of their assets, they are encouraged to save more.
  • The tax on securities influences rather the distribution, in securities between stocks and bonds.

Title analysis

  • Some analysts believe that lessons can be learned from past developments and that a stock will tend to always follow the same type of development. They draw up graphs and spot the high points, the low points … This is called chart analysis.
  • A more widespread method (and only possible in the event of market introduction): the so-called fundamental analysis, which takes into account the characteristics of the issuer (another name of the company that issues securities).

The PER (price earnings ratio) is the ratio between the share price and the expected profit (deducted from the fundamental analysis described above). It makes it possible to compare companies in the same sector, and to determine whether a share is expensive or not. Several other methods are used by financial analysts.

If it is a question of analyzing a company in order to buy its bonds, the analysis rather relates to its capacity to repay its debts evaluated by rating agencies, like Moody’s, Fitch, or Standard & Poor’s which rate the companies according to their risk (of the best, AAA, at least good CCC or even D). The valuation of bond prices is relatively complex, and rather reserved for specialists.

More complex concepts such as sensitivity, which measures the change in the price of a bond compared to a change in the interest rate, come into play here.

Place stock market orders

The best execution rule

In addition to the fact that investor orders may, if they wish, be executed elsewhere than on a regulated market, the new rules introduce the new and essential concept of ” best execution  ” of orders, which obliges the service provider to investment (the financial intermediary) to take into account a series of criteria to ensure that the best possible result is obtained when executing the orders of its clients.

In this context, each investment service provider must set up its own order execution policy (how it executes orders, places of execution of orders it has selected), which will be subject to agreement of the customer and whose effectiveness should be monitored. The new texts also significantly strengthen the information obligations of investment service providers towards their clients.

Investors will enjoy the same level of protection, whether they choose a domestic or Foreign Service provider.

The different possible modes of execution 

There are three modes of execution or three kinds of places where orders to buy or sell financial instruments can be executed:

  • The regulated markets are traditional stock exchanges.
  • Multilateral trading systems. These are groups of investment service providers who will compete directly with the regulated markets. There are 6 multilateral trading systems approved in France: Paris, the Free Market and Alternativa which allow shares to be traded; MTS, NYSE BondMatch and Galaxy which allow bond trading.
  • Investment service providers acting through systematic internalisation. This function with a barbaric name consists for an investment services provider, of interposing between its buying and selling clients, by systematically countering orders to buy and sell of its clients. In other words, the buyer does not buy directly from the seller, as in the classic system in force in France, but from the intermediary, who himself buys the corresponding securities from another of his customers. It is the English “book” system and only the balance of orders not finding counterpart in this internal system is carried on the market.

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