There have been numerous market theories developed over the years which attempt to explain the pricing behavior of stocks.
These theories provide valuable insight into the seemingly irrational movements observed in the stock market. The task of analyzing the stock market is simplified when the investor has a solid understanding of the mechanisms which drive the markets.
Some theories such as Elliott Wave Theory and Wyckoff Market Analysis give the stock investor a better understanding of how stock prices move. Many new stock investors are under the illusion that markets continuously move upwards in a straight line. The Elliott and Wyckoff theories will dispel those illusions.
The Efficient Market Hypothesis is based on the notion that stock prices quickly reflect any new information. Indeed any new information which will affect the views market participants have over a stock or the market overall are rapidly absorbed into the prices. This information will often drive market prices in the opposite direction and the Efficient Market Hypothesis rationalizes that speculation and market participants with inside knowledge drive market prices before the information is publicly known and once the information is publicly known there is nothing left to speculate on.
Other aspects of the Efficient Market Hypothesis are more controversial, such as the stock price accurately reflecting the fundamental valuation of the company, which business economics dispels as being incorrect.
The Principle of Supply and Demand is the basis which moves stock prices. Simply put, when there are more buyers wanting to purchase stocks than there are sellers who are willing to sell their stocks, this puts upward pressure on prices and prices rise.
A useful concept in market analysis is that inflation and the price paid for a company’s earnings are inversely related. High inflation tends to produce lower average PE ratios and low inflation tends to produce higher average PE ratios.
The inflation PE ratio relationship comes about from the rotation of capital between stocks and bonds. Basically when inflation is high, the coupon payments from bonds are also high and the investor receives a good return on a relatively low risk investment. This leads investors to allocate more money to bonds at the expense of stocks which leads to lower PE ratios on average. When inflation is low the coupon payments from bonds is also low and investors naturally seek better returns and allocate more money to stocks thus driving up stock prices and their PE ratios.
Another useful theory is Dow Theory which is based on the notion that the level of business activity of industrial companies and transport companies are directly related. When the sales of goods provided by industrial companies is increasing it is reasonable to expect that the demand on transport companies which transport these goods will also increase. Dow Theory goes one step further than the other theories and provides a simple to use means of determining whether the current stock market cycle is bullish or bearish by using these two Dow Averages.