Why Do Stocks Go Up?

Benjamin Graham, widely regarded as the father of value investing, once asked investors to imagine they owned a business with a very unusual partner. Every morning, this partner, whom Graham called Mr. Market, would knock on the door and offer either to buy your share of the business or sell you his. Some days he was incredibly optimistic and willing to pay an absurdly high price. Other days he was convinced the world was falling apart and offered to sell his share at a steep discount. No matter what Mr. Market was blabbering about that day, the business itself hadn't necessarily changed. Only his mood had.

More than seventy years later, Graham's analogy is still one of the best ways to understand how the stock market actually works. Many people think the stock market exists to tell us what companies are worth. In reality, it tells us what millions of investors are collectively willing to pay for those companies at a particular moment in time, and those are two very different things. Separating a company’s value and its share price is one of the most important distinctions an investor can make.

That's why you'll occasionally see a company report record revenue, record profits, and optimistic guidance, only for its stock to fall 10% the next day. It isn't because the market ignored the good news; the market could have just been expecting something better.

The Stock Market Lives in the Future

One of the biggest misconceptions about investing is that stock prices reflect how well a company is doing today. They do not. A stock price reflects what investors believe a company will look like years from now.

When you buy a share of stock, you're purchasing a tiny ownership stake in a business. The value of that business isn't determined by last quarter's earnings alone. It's determined by every dollar of profit investors expect the company to generate over the coming years. There are countless analysts and institutions that are constantly trying to estimate those future profits, and every trade that takes place moves the stock price toward what investors collectively believe those future cash flows are worth. Two companies can be earning the exact same profit today and can trade at dramatically different valuations – one of them could be worth $100 billion, and the other could be worth $50 billion. If investors believe one company has much stronger growth ability over the next decade, they'll happily pay a much higher price for it today.

A company like Nvidia is a perfect example. Investors aren't valuing Nvidia based solely on the chips it sold last quarter. They're valuing it based on what they believe artificial intelligence spending, data center demand, and the semiconductor industry could look like years into the future. Whether those expectations end up coming to fruition is another question entirely, but those expectations are what drive the stock price.

Everything You Know Is Already Known

Public information is almost always already reflected in a stock's price. That may sound obvious, but it's something many new investors overlook. Reading that Apple sold millions of iPhones or that Costco continues growing its membership base doesn't provide a hidden advantage because everyone else can read the exact same headlines. Professional investors spend their entire careers analyzing these businesses. Investment banks employ teams of analysts who build detailed financial models, hedge funds interview suppliers and customers, and institutional investors attend earnings calls looking for even the smallest clues about future performance. The millisecond information becomes public, it’s basically priced in. There are institutional algorithms that parse the entire internet and SEC filings that trigger immediate price jumps before anyone even finishes reading headlines. However, for larger and more complex economic data, price adjustments can ripple out over several hours or days.

This concept is known as the Efficient Market Hypothesis. While economists continue debating exactly how efficient markets are, the underlying idea is still important: prices already reflect publicly available information. That doesn't mean markets are always right, because they aren’t, but it does mean that making money consistently is incredibly difficult because you're competing against millions of educated investors who all have access to essentially the same information.

Expectations Move Stocks

Suppose analysts expect a company to earn $500 million this quarter. Instead, it reports $540 million. Maybe demand is stronger than expected, or costs came down faster than anticipated, or the business is improving quicker than Wall Street realized. Investors adjust their expectations for future earnings, and the stock often rises. Now consider the opposite situation. A company reports the highest revenue and profits in its history, but investors had convinced themselves that the results would be even stronger. The business is objectively performing incredibly well, yet people’s expectations had become so optimistic that "great" was no longer enough. The stock falls. A company doesn't need to have a bad quarter for its stock to decline; it only needs to perform worse than investors were expecting. 

A Great Company Can Still Be a Bad Investment

Finding an amazing business is only half the battle. The other half is deciding whether everyone else has already figured out that it's amazing. If someone offered you the opportunity to buy one of the greatest businesses in the world with loyal customers, incredible management, enormous profit margins, and years of future growth, but investors have already recognized those strengths, they'll likely be willing to pay an enormous price for the stock. Expectations become so high that the company has very little room for disappointment.

Nvidia has been a great example of this over the past couple of years, as perfection became the minimum requirement for them.

On the other hand, a struggling company with extremely low expectations sometimes only needs to deliver results that are slightly less disappointing than investors feared for its stock to soar. The big takeaway from this is that investing is more about identifying situations where the market's expectations are either too optimistic or too pessimistic than finding good businesses.

The Role of the Federal Reserve

If you've ever wondered why the stock market reacts so strongly whenever the Federal Reserve changes interest rates, the same logic applies. Stocks get their value from future profits. The further those profits are in the future, the less valuable they become today when interest rates rise. Investors suddenly have access to higher returns from relatively safe investments like Treasuries, so they demand even greater future returns before they're willing to buy stocks. The opposite happens when interest rates fall. Future earnings become more valuable, which is one reason growth companies often perform well during times when interest rates are low.

Mr. Market Is Still Knocking

Benjamin Graham's Mr. Market has survived for more than seventy years because the analogy captures something fundamental about investing. Every morning the market offers new prices for every public company in the world. Sometimes those prices are driven by careful analysis, but on a day-to-day basis, most of the time they're influenced by excitement, fear, uncertainty, or changing expectations. The market's opinion changes constantly, but the underlying businesses usually don't. Understanding that distinction changes the way you look at investing. A falling stock price doesn't automatically mean a company has become worse, just as a rising stock price doesn't automatically mean it's become better. More often than not, it means investors have changed their expectations about the future. The stock market is trying to predict what that company will become tomorrow, and sometimes it gets close, but a lot of the time Mr. Market just has a bad day.