Security Prices Move Up and Down for Two Basic Reasons: Business Reality or Supply and Demand

Security prices move up and down for two basic reasons:

• to reflect business reality (or investor perceptions of that reality) or 
• to reflect short-term variations in supply and demand. 

Reality can change in a number of ways,

• some company-specific, 
• others macroeconomic in nature. 

Company-specific factors

• If Coca-Cola's business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value. 
• If Aetna's share price plunges when a hurricane causes billions of dollars in catastrophic losses, a decline in total market value approximately equal to the estimated losses may be appropriate. 
• When the shares of Fund American Companies , Inc., surge as a result of the unexpected announcement of the sale of its major subsidiary, Fireman's Fund Insurance Company, at a very high price, the price increase reflects the sudden and nearly complete realization of underlying value. 

On a macroeconomic level

These factors could each precipitate a general increase in security prices:

• a broad-based decline in interest rates, 
• a drop in corporate tax rates, or 
• a rise in the expected rate of economic growth.

Investors should expect prices to fluctuate

The Relevance of Temporary Price Fluctuations

In addition to the probability of permanent loss attached to investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value.

Many investors consider price fluctuations to be a significant risk:  if the price goes down, the investment is seen as risky regardless of the fundamentals.

But are temporary price fluctuations really a risk?

• Not in the way that permanent value impairments are and 
• then only for certain investors in specific situations.

It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.  The reality may only become apparent after the fact.

While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.  

Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.

A Subnormal P/E

When a stock is selling at a P/E significantly lower than that of its competitors, an investor will want to know why?

A low P/E does not necessarily mean higher risk, though the company should be studied with that possibility in mind.

• The low P/E stock may be selected anyway if, for example, it is a cyclical stock at a low in its cycle.   Cyclical stocks - automobile manufacturers are the most notorious among them - periodically develop fire-sale P/E ratios.  
• Other out-of-favour stocks also can drop to surprisingly low P/Es.

On the other hand, if a stock is cheap in terms of its multiple for a troubling reason (or permanent deterioration of  business  fundamentals), such as pending depletion of oil or mineral reserves or a patent expiration, the value investor may want to shop elsewhere.




Comment:
Often the low P/E is appropriate for the stock as it is perceived to have poor potential for growth or its earnings are poor, volatile and less stable.