How Stock Market Trends Work

You've seen movies in which frantic stock traders are buying a thousand shares of a hot stock or dumping shares of a plummeting stock. You've seen commercials for brokerage firms that claim to have exciting prospects and strong portfolios. And you've probably heard a hundred different ways to predict the rise and fall of the stock market.

How do these traders and firms predict which shares will hit big? How do they know when to sell?

The truth is there is no magical way to predict the stock market. Many issues affect rises and falls in share prices, whether gradual changes or sharp spikes. The best way to understand how the market fluctuates is to study trends.

In this article we will discuss stock market trends, which help investors identify what stocks to buy and when. Keeping track of upswings and downswings over the history of individual stocks, as well as being aware of market-wide trends, helps investors plan buying and selling.

Many factors affect prices in the stock market, including inflation, interest rates, energy prices, oil prices and international issues, such as war, crime, fraud and political unrest.

Sudden rises or drops in stock prices are often called spikes. Spikes are extremely difficult, if not impossible, to predict. Stock market trends are like the behavior of a person. After you study how a person reacts to different situations, you can make predictions about how that person will react to an event. Similarly, recognizing a trend in the stock market or in an individual stock will enable you to choose the best times to buy and sell.

Go to the next page to learn about the whims of the stock market. You'll also find out what market analysts mean when they talk about bull markets and bear markets. Which animal is fiercer?

What Causes Change in the Stock Market?

So just what makes those ticker numbers change?

Inflation: Inflation is a rise in prices across the board. Inflation causes your dollar to be worth less. Inflation is the reason a car costs $7,000 in 1981 and $17,000 in 2001. Over the long term, inflation is good, because it means consumers are spending a lot of money -- the economy is robust. When inflation is too high, though, consumers pull back and spend less. After all, $5 is a lot of money to spend on a candy bar. When consumers spend less, companies don't make as much money. When companies don't make money, investors lose confidence in those companies. Many investors sell their stock because they believe the stock is worth less and is only going to decrease in price. As the demand for the stock decreases, the price of the stock decreases. When this happens to many companies in the stock market, the stock market experiences a downward shift.
Interest Rates: To bring inflation under control, the Federal Reserve System can raise the federal funds interest rate, which is the interest rate banks pay on loans they take from the Federal Reserve. Think of the Federal Reserve as a credit card for banks. When banks have to pay a higher interest rate, they often raise their own interest rates on loans and credit card accounts for businesses and individuals. This means that businesses and consumers must pay higher interest on borrowed funds. This usually causes consumers to spend less and businesses to borrow less. When businesses don't borrow money to develop that new widget, they tend to grow at a slower rate. When consumers don't buy things and businesses don't grow, companies' profits decrease, causing a stock price decrease. Conversely, when the Federal Reserve cuts the interest rate, investors tend to get excited. The cut means banks will be borrowing and lending more and at better rates. Businesses will grow and consumers will spend. Company profits will go up. Investors tend to buy, buy, buy!
Earnings: When Widget Co. reports profits, everyone wants a piece. Profit means the company is doing well. But maybe after a while, people grow tired of widgets and want to buy the new whatsit instead. Widget Co. reports lower profits. As you saw with inflation and interest rates, when a company reports lower profits, investors lose confidence in the company and sell their stock, which decreases the value of the stock.
Energy Prices: People always need energy. Electricity and natural gas keep us warm, cook our food and keep our computers happy. Therefore, the demand for energy is pretty constant. Only major changes in energy costs have a significant effect on the stock market.
Oil Prices: People almost always need oil, in the form of gasoline. When gas prices are high, however, some people look to alternative methods of transportation -- carpools, public transportation, bikes, etc. Others keep paying the high price but, as a result, buy fewer consumer goods. The stock market tends to react negatively to high oil prices.
International and Domestic Issues: War tends to affect the stock market negatively. The same goes for crime, fraud, and domestic or political unrest. Consumers worry when CEOs steal money, terrorists kill innocent people, or politicians are involved in serious scandals. Who knows what will happen next? Consumers save their money. Businesses make less money. Investors tend to dump their stocks, causing a fall in the market.
Fear: Besides being afraid of the market consequences of war, oil prices or a federal interest rate hike, investors are afraid of losing their money. Investors tend to dislike seeing their money dwindle as the price of their shares decreases.

All these factors cause changes in the market. But what about the long-term trends? Learn about bull and bear markets next.

Bull Markets and Bear Markets

No one really knows the exact origin of the terms "bull" and "bear" to describe the stock market, but their meaning is clear. The most important thing to know about these terms is that they describe long-term trends, not short-term changes. Bull and bear markets are usually measured in years.

A bull market is a rising market. In a bull market, investors are positive. The economy tends to be strong. Unemployment is low. Consumers are spending money, which increases business profits. When businesses profit, investors demand to share a piece of the pie -- they buy stocks and hang on tight to watch the money roll in. The supply of shares, then, is low -- no one wants to give up their piece of the widget pie. The competition to acquire those much-coveted shares becomes fierce, which drives the prices up even higher. Investors take risks because they feel good about their chances of making the big bucks.

A bear market is a declining market. It tends to begin with a sharp drop in stock prices across the board. There is usually an eye in the storm, during which stock prices increase. But the storm returns, of course, and the bear market falls and falls and falls. History has shown that a bear market tends to level out at 40 percent lower than when it began. Particularly bloodthirsty bears, like the one that ravaged the U.S. during the Great Depression, might level out at about 90 percent lower [source: Incademy].

In a bear market, the economy tends to be weak. Unemployment increases. Consumers spend less, which results in lower business profits. As we've seen, this devalues a given company's stock. Investors tend to sell their stocks before the value decreases too much. Investors don't want to take risks because they don't feel good about their chances.

Investment Strategies -- How to Ride the Bull and Tame the Bear

The best strategy to make money in a bull market is to recognize the trend early and make smart buys. Buy low -- sell high.

It may seem counterintuitive that you can make money during a bear market. Here are a few ways you can tame the bear:

Short sell: A short sell is a trade that consists of borrowing stock you don't own, selling it, waiting for the price to fall, then buying it back at a lower price, thus obtaining a profit.
Invest in U.S. Treasury bonds: Bond interest rates tend to rise during bear markets, which makes for an attractive opportunity during a time of uncertainty
Buy defensive stocks: This is a low-risk way for investors to keep their money in the stock market. A defensive stock is so named because its value doesn't fluctuate much. Utility stocks (energy, water, etc.) are popular defensive stocks.

The Long Run

History has shown that the stock market always rises over the long term. Bear markets and crashes happen, but the market always makes a comeback and eventually rises higher than it ever was before.

Many professional investors say that determining your investments solely on the basis of whether the market is bullish or bearish is unwise. It is better to base investments on research into strong, competent businesses with plenty of growth potential. Over time, educated and informed investments tend to profit more than investments based on rumor, fear, guesswork and superstition.

To learn more about how stock market trends work, you can follow the links on the next page.

Lots More Information

Sources:

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