The topic is deliberately broad so that you may research and investigate topics which interest you.
This being said, the general background is to put yourself in the position of a first time investor in the stock market, and to consider some of the broader economic issues which may impact on stock market prices, of which there are a wide variety.
Some of these factors include:
supply and demand
economic growth rate
What you need to do in your paper, therefore, is to explain how these factors impact on the stock market, either positively (prices going up), or negatively (prices going down. You will need to state the basic economic theory you are applying, and with the use of diagrams or graphs, explain how this impacts stock market prices.
You may examine the Australian stock market, or international stock markets as you see fit.
In theory, the stock market works in a similar way to any other economic market (Hafer & Hein, 2007). It is where the supply of stocks meets demand; buyers and sellers interact and the forces of demand and supply govern the market. The relationship between demand and supply will determine the level of prices in the market. However, movements of stock prices are very volatile and may seem not to be in harmony with economic factors that affect prices. Despite this perception especially for a new investor, many economic factors affect the stock market. These factors have a significant influence in the movement of share prices and the stock market in general.
Generally, many investors will rush in to acquire stocks that are perceived to have greater returns through dividends (Hafer & Hein, 2007). Because of this, the factors that appear to make firms playing in the market to be more profitable will tend to increase the prices of shares. Prices of stocks for companies within the same industry tend to move more or less simultaneously. This is because the market conditions will affect the firms within the industry in almost the same way. In this essay, we will look at some of the economic factors that affect the stock market and how they play a role in price movements.
This is one of the fundamental concepts in economics. It forms the basis of economic analysis. The relationship between demand and supply gives us the equilibrium price and quantity that the buyers and sellers will settle for in any market (Salvatore, 2011). Prices of commodities tend to increase with an increase in demand and reduce with increase in supply. The reverse is true where the prices will reduce when the demand falls and the supply increases.
This age-old model in economics is of a major significance in the stock market. A high supply of stocks in the market tends to lower the prices. Low prices invite more investors to purchase the stocks hence it creates a demand for the stocks. After a while of increasing demand, the supply starts to dwindle and the prices will increase. This increase in prices will be because the investors show that they are willing to pay more for the performing shares. The prices will increase to a point where they will be too high that the investors will move on to other shares that are cheaper but of the same performance levels (Petroni, et al., 2013).
Economic growth rates
There is, however, a point where the supply meets the demand. This is the equilibrium point in the market where both demand and supply balance. The figure below illustrates how the changes in demand and supply will affect the equilibrium point.
The figure above shows the relationship between demand and supply. The initial demand curve for stocks is represented by the line DD while the initial supply curve is the line SS. Where the demand and supply curve intersect (E*) is the initial equilibrium point in the market. When the demand increases, the demand curve will shift from DD to D1D1. If the supply remains the same, there will be more money chasing after fewer stocks (Q1) and the price will increase from P* to P1. The equilibrium will now be at point E1.
Increased prices mean that the firms are willing to supply more stocks because they will be able to raise more capital due to the high demand and attractive prices. They will increase the quantity supply from SS to S1S1. By increasing the supply, lesser money will be chasing after fewer stocks and the price will reduce. However, we will now have a newer equilibrium quantity (Q2) at the same price P*. The new point of equilibrium in the market will now be at point E. we can observe that the price remains the same as the initial price P* but the quantity has changed due to the changes in demand and supply (from Q* to Q2).
Economic growth is measured using a number of indicators with the most important being the changes in the gross domestic product (GDP). The GDP refers to the total monetary value of economic goods and services produced within the geographical confines of the economy in a certain fixed period (Gordon, 2014). The time frame is usually one financial year but it can be broken down into quarters depending on the analysis. High economic growth rates, characterised by a high GDP, indicate that an economy is healthy and has a good economic activity that will translate to production that is more effective. The investor will be willing to put more of their money in such an economy because they expect better returns on their investments.
The GDP is an aggregate of investment by the private sector, consumption of the goods and services produced within or imported, government expenditure on the improvement of infrastructure and better service delivery, and the net exports (exports fewer imports). All these factors are directly related to the GDP and an increase in any of them will have a positive effect on the productivity of the economy (Gordon, 2014). This ensures better performance of the firms in the economy, increases sales and earnings, and higher returns in the stock market. Investors are thus attracted to such an economy. In addition, the investors can compare the GDPs of different countries and hence make a more informed decision on where they think is best to invest.
However, an investor needs to be careful when considering the health of the economy using the GDP as an indicator. This is mainly because the GDP is an indicator that portrays the past performance while the investor should be more interested in the future performance so that they can predict the feasibility of returns on their investments. Therefore, the investor needs to analyse stocks in terms of their current values and the returns that they will bring back in the future (Brooks & Nojin, 2010).
This refers to the changes in the characteristics of the population that constitutes the investors. The characteristics that mainly affect investment are the age and the earning ability of the investors. Two dynamics arise concerning the changes in demographics. First is the younger and middle-aged investors who are peak investors. They earn more and so tend to invest more in the stock market. The more the section of these investors in the population, the higher the demand for stocks. This will increase the prices of stocks. Second is the fact that older investors tend to pull out of the market to meet the needs of retiring. These investors lower the demand and hence the price of stocks.
Unemployment is another part of demographics that shows the percentage of the population that is currently not in employment and hence do not participate actively in economic activity. Employment rates will indicate how healthy an economy is in a similar way to the GDP (Gordon, 2014). It is used to show how productive the economy is presently and how it will be in the future.
Investors need information on the unemployment rates of the economy because it offers a viewpoint on how the stock market will behave. This is because when there are high levels of employment, there is high consumption due to increase in the general disposable income in the population. More commodities produced by the firms will be consumed and hence there will be more revenue and returns for the investment in stocks. Furthermore, the more people there are in employment, the more the economic output and savings. As a result, of the employment figures, the stock market will tend to fluctuate in performance because the two factors are directly and closely related.
This refers the cost of capital used by investors to make investments in the stock market. In Australia, interest rates are set by the Reserve Bank and the commercial banks. Interest rates can affect the activity and prices in the stock market in a big way.
High-interest rates make the capital to be very costly. This means that there will be less money to invest and hence less demand for the stock. The demand will reduce more with investors preferring to invest in more risk-free instruments that will guarantee them their returns. This, in turn, will drive the prices of stocks down.
In addition, the investors will require a higher return on their investments to cover the costs they incurred to acquire the money used to invest. On the other hand, the companies cannot vary their returns in the short run. This will have the effect of reducing the prices of stocks (Brooks & Nojin, 2010).
As we have seen, the stock market behaves in a similar fashion to any economic market and the factors that affect the markets will most definitely affect the performance of the stock market. Most of the factors are interrelated and an effect on one could have an effect on the others and end up affecting the market. However, some factors may not be so obvious and the investors need to practice caution to ensure the safety of their investments by making informed decisions.
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