What Really Drives Market Movements?

Why share prices can move dramatically even when the underlying value of an investment has barely changed

When financial markets move sharply, there is rarely a shortage of explanations.

A weaker economic figure is blamed for a fall in equities. A change in inflation expectations is linked to movements in bond yields. A company’s share price rises after an announcement, and analysts explain how the news has changed their assessment of its future earnings.

These explanations sound logical. But they can give us a misleading impression of how markets actually work.

In the short term, markets are not always driven by investors calculating what an asset is genuinely worth. Often, investors are trying to anticipate what other investors will do next.

The market as a guessing game

Imagine a weaker-than-expected US employment report is released and the S&P 500 falls sharply.

One explanation might be that investors have reassessed the outlook for economic growth and concluded that US companies are now worth less than they previously thought.

But another possibility is that investors are simply anticipating how everyone else will react to the weaker data.

If investors believe other market participants will sell, they may sell first. Others see prices falling and follow. Before long, the market has moved significantly, even though there may have been little change in the underlying long-term value of the companies involved.

This is sometimes described as a Keynesian beauty contest. The objective is not necessarily to identify the correct answer, but to anticipate what other participants believe the correct answer will be.

Investors are not simply asking, “What is this asset worth?” They are also asking, “What will everyone else think it is worth?”

Sometimes, that second question dominates.

What do we mean by fundamentals?

In investing, fundamentals means the underlying financial and economic factors that influence an asset’s long-term value.

For a company, that could include revenue, profits, cash flow, debt, competitive position and growth prospects.

For a bond, it could include the issuer’s ability to repay, interest rates and creditworthiness.

These factors are important, but they do not necessarily explain every short-term movement in market prices.

Markets can move because investors are responding to one another rather than directly reassessing an asset’s underlying value.

A piece of economic data may cause investors to expect others to sell. That selling pushes prices lower, which encourages further selling. The resulting price movement can then become the story itself.

When prices can change reality

There is another important relationship between market prices and underlying value: sometimes price movements can influence the economic reality behind them.

Consider government bonds. If investors become concerned about a country’s fiscal position, they may demand higher yields to hold its debt. Those higher yields increase the government’s borrowing costs, potentially worsening its fiscal position and creating further concern among investors.

What began as a change in market sentiment can therefore become a genuine economic problem.

This feedback loop is sometimes associated with reflexivity. Asset prices and economic fundamentals are not entirely separate. At certain points, they can influence one another.

So, what really matters?

The answer depends heavily on the time horizon.

In the short term, sentiment, expectations, positioning and investor behaviour can dominate. Underlying economic value may tell us surprisingly little about an individual day’s market movement.

In periods of extreme stress, fundamentals can become much more important. When a company is facing financial distress, for example, its ability to generate cash and meet its obligations becomes critical to the value of