5 Factors That Drive Stock Prices

Central banks, market sentiment, and valuation all play a role.

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Over the next few years, emerging markets countries like China and Brazil are expected to far outpace developed nations like the United States in terms of GDP growth, but that doesn't necessarily mean their stock markets will also outperform. When deciding how to allocate your stock portfolio to different regions of the world, there are many factors investors should consider. A stock market's valuation, the country's expected economic growth, and the actions of its central bank all play a role. Here are five factors that drive stock prices:

Market sentiment. On a day-to-day basis, it's impossible to predict what will happen in stock markets worldwide. One week, the market is up on better-than-expected economic indicators, and the next it's down because of a new development in the sovereign debt crisis in Europe. "It's so unpredictable," says Roger Aliaga-Díaz, senior economist with the investment strategy group at Vanguard. "That's one of the reasons that we focus more on the long term."

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Growth expectations. Research over the years has proven that higher GDP growth doesn't necessarily translate into higher stock returns in a particular country. The correlation between the two is actually negative. Take China, for example. From the beginning of 1993 through the end of 2009, China's GDP grew at an annualized rate of 11 percent, which ranked it first among countries represented in the MSCI All-Country World Index (ACWI), according to a research paper released by Heckman Global Advisors. During the same time period, the MSCI China Index returned a measly 0.6 percent per year, on average. On the other hand, from the start of 1989 through 2009, the U.S. economy grew at a much slower annualized rate of 5 percent, while the MSCI USA Index returned an annualized 9 percent.

Investors should pay attention to analysts' expectations for higher or lower economic growth in a given country. "You want [to invest in] markets where you find GDP growth is accelerating," says Leila Heckman, senior managing director, international equity, at Mesirow Financial in New York. "If you knew the bottom of a recession, that's probably the best time to be investing in a market." Heckman says she generally advises her clients to avoid the fastest-growing countries because sometimes that growth can be priced into the stocks very quickly. Currently, she's telling clients to underweight China in their portfolios.

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Valuation. In the long term, valuation plays an important role in driving stock prices in a given country, says Jay Ritter, a professor of finance at the University of Florida. Price-to-earnings ratios (P/E ratios) are used to measure the value of stocks. Trailing P/E ratios track historical earnings, while measures like forecasted P/E ratios track expected earnings. Both can be helpful in determining how expensive or cheap a stock (or stock market) looks. One of the most commonly cited measures of the price of U.S. stocks is the Shiller P/E ratio, which divides the level of the S&P 500 by the average earnings of the S&P during the last 10 years. "When this ratio is high, future stock returns will be low. But anything can happen for a year or two, or even five. When the Shiller P/E is low, it is a good time to buy stocks," Ritter says.

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Momentum. Despite what's going on in the economy or with a particular company's fundamentals, investors will sometimes trade on momentum. "Often investor psychology can pile on and drive a stock price higher and higher, well above fair value, and that can happen for an extended period until finally there is a correction," says Steve Cucchiaro, founder of Windhaven, a Boston-based investment advisory group. "Conversely, there is a time when stock prices can be pushed down."

Central bank activity. Generally, you want to invest in a country in which the central bank is lowering interest rates. While interest rates remain at virtually zero in the United States, other rapidly-growing nations are being forced to raise rates because of inflation concerns. So while it seems that economic growth would be beneficial for stock prices, too much growth can actually have a negative effect. "As these economies like China and Brazil grow faster and faster, they begin to overheat, then inflationary pressures rise, then the central banks decides that they don't want inflation to get out of hand, so they start to raise interest rates, and usually, that's a long process," Cucchiaro says. "That acts to cut into stock valuations."