Why Do
Stocks Go Up?
Or not?

by Ann Coleman (TMF

Alexandria, VA (January 25, 1999) -- Why do stocks go up? A lot of investors seem to think that that is one of those impossible-to-answer questions, kind of like "What do women really want?"

(For the record, one thing that women really want is to not be lumped into one huge group and treated as if they all want the same thing.)

I won't presume to speak for an entire gender, but the question about stocks is not really that tough to answer. What do stockholders really want? Earnings. If a company can deliver earnings, the price will go up.

It's ALL about earnings -- how much money the company makes (or doesn't make) -- good old fashioned profits -- the bottom line. This is a true answer that is very easy to lose sight of when Internet stocks are selling for hundreds of times the earnings that they don't even have, yet, and in-the-red IPOs that end in ".com" rise to higher market capitalizations during their first day of trading than companies that actually make lots of money and have been doing so for years.

You see, another answer, but one that is "less true," is that stocks go up because of hype. Hype, momentum, the greater fool theory -- all ways to describe the seemingly irrational way some stocks behave. But when you look closely, you will see that the hype is always about earnings.

I said this answer was "less true" because although stocks do go up because of hype and momentum, they also go back down eventually unless the earnings are there to sustain them. When hype-based momentum turns around, it can get ugly.

One of the few indisputable facts of investing is that over the long term, stock prices rise because company earnings rise, or vice versa. But the fact that stocks rise because of earnings is only long-term truth. Prices don't track earnings that closely over short time periods, and even long-term, the relationship is not necessarily precise. There's a lot of room for hype.

At any given point in time, stock prices within some earnings-dictated range are more influenced by the market's perception of what earnings will be. Not what earnings are, but what they will be. Sometimes those perceptions are realistic, sometimes they are wildly unrealistic. But always the perceptions are about earnings.

One of Wall Street's truisms is that if you know the price of a stock will go to $50 tomorrow, it will go to $50 today. Think about it. If you know a stock is going up, the natural reaction is to buy it. If "everyone" knows it 's going up, and, therefore, "everyone" starts buying, what happens? Increased demand plus limited supply equals increased price. As the price approaches what "everyone" thinks it will be tomorrow, demand slows to equal supply, and the price levels off.

In effect, investors are voting with their dollars about what they think a company's earnings will be. So when the market (meaning the aggregate "votes" of all the persons buying and selling that particular stock) thinks that earnings are going to increase in the future, the stock will go up. When that perception changes, the stock will go down, sometimes precipitously. If earnings go down when shareholders aren't expecting it, watch out below.

Those daily adjustments to the price can seem baffling. Why should a company be worth $50 a share today, when yesterday it was worth $45? When you realize that the company has five hundred million shares outstanding and that a five dollar price change changes the value of the company by $2.5 billion, it seems even crazier.

Day-to-day and even month-to-month price changes are often crazy. That's a really good reason for not watching your portfolio too closely. Concentrating on the company's long-term profit picture is far healthier than worrying about what "everyone else" thinks of your stock.

Now, the Foolish Four and the other Dow Investing strategies don't hold stocks for the true long term, of course. They take advantage of some of those crazy short-term fluctuations to buy stocks when the market has overreacted to bad news or a drop in earnings. Within a year or two, companies as big and as successful as the Dow companies tend to recover from whatever bad news and/or bad conditions were depressing their price and the price resumes its traditional relationship to earnings.

Speaking of news, one perception is that bad news about a company causes the stocks price to drop. This is not exactly how it works. It still comes back to earnings. Bad news is bad news because it can negatively impact those earnings. Bad news can be anything from an environmental disaster that will cost millions to clean up to the death of an executive who knows how to keep costs in line to the rise of a new competitor that may siphon off customers, but it's only bad news if there is a possibility that it will decrease earnings.

Tomorrow, we will look how 3M (NYSE: MMM) rose $5 a share today on news that its earnings are well below estimates from just over a month ago. Wednesday, we'll look at just why earnings are so important, and Friday, we will take a close look at that traditional relationship between price and earnings, the world famous P/E ratio.

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

01/25/99 Close
Stock  Change   Last
CAT  +  13/16  44.56
JPM  +1  1/8   104.25
MMM  +3 15/16  75.25
IP   +1  1/16  42.06
                   Day   Month    Year   History
        FOOL-4   +2.77%  -1.10%  -1.10%   0.37%
        DJIA     +0.91%   0.24%   0.24%  -0.16%
        S&P 500  +0.68%   0.38%   0.38%   1.77%
        NASDAQ   +1.30%   8.05%   8.05%   9.54%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     44.56     3.44%
 12/24/98   14 3M            73.57     75.25     2.28%
 12/24/98    9 JP Morgan    105.51    104.25    -1.19%
 12/24/98   22 Int'l Paper   43.55     42.06    -3.42%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1069.50    $35.50
 12/24/98   14 3M          1030.00   1053.50    $23.50
 12/24/98    9 JP Morgan    949.62    938.25   -$11.37
 12/24/98   22 Int'l Paper  958.12    925.38   -$32.75

                             Cash     $28.26
                            TOTAL   $4014.89