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YOU DECIDE: What should you do about the stock market?

March 08, 2007

By Dr. Mike Walden
North Carolina Cooperative Extension Service

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.
It's time for a lesson in the stock market.

Recently the market caught the eye of almost everyone when it dropped 400 points in a single day. Although that was a relatively small decline on a percentage basis, the downward plunge caused many investors to worry about long-run trends and rethink their Wall Street investments.

It's easy to get used to a rising stock market - and almost take the gains for granted - when the market continually moves up, as it has for much of the last couple of years. But when the market hits a bump in the road, we all begin to worry and question where stocks are headed.

So with these issues in mind, let me address five common questions people often ask about the stock market. The answers may not make you rich, but perhaps will calm your nerves and give you insights into how the market works.

What causes stock values to rise and fall?

Fundamentally, the value of a stock rises when the company issuing the stock performs better; in other words, it makes more profit. Performance is usually measured by total profits (in investment lingo, "net earnings") divided by the total number of shares of stock issued. So the value of a stock should rise when this measure improves, and likewise should fall when performance tumbles.

OK, can I just look at past profits to determine where a stock is headed?

Oh, if it were only that easy! The problem: the stock market not only looks back, but also looks forward, and the weight it puts on forward-looking is much greater than the weight on backward-looking. In fact, most financial experts would argue that a stock’s value today is almost exclusively based on the company's expected future profits (per share). Past profits and past performance are only important to help predict future profits.

Do only the actions and decisions the company makes affect its stock value?

A company could be the best run and most efficient, have the best profit record and still see its stock value decline if the overall economy is expected to sour. There are micro- (meaning company) and industry-specific factors affecting a stock value, as well as macro - or economy-wide - factors that push and pull on stock values.

This explains why a company could be zipping along, doing everything right and earning a good profit with nice increases in its stock value, when boom! its stock plunges because there's been a change to a more negative assessment of the future overall economy.

Has the mood about the overall economy turned gloomier?

Some analysts say yes, and it's why the market took the big hit it did recently. Several indicators, such as durable goods orders, industrial production, housing sales and mortgage delinquencies, have turned "bearish." Also the federal government just announced economic growth at the end of 2006 was only two-thirds as strong as it had previously reported. And the Federal Reserve appears to have become tighter in supplying money and credit to banks. So if the overall economy is slowing, then it makes sense that the stock market will make a downward adjustment.

What should an investor do?

Should you take your money and run for the hills, getting as far away from the stock market as you can? Or should you be a "contrarian" and buy when everyone else is selling?

I'll echo advice that you've probably heard from many sources. If you're in the stock market for the long run, meaning you won't need the cash for several years in the future, then stay put and actually continue investing. One caveat: make sure you invest in a wide range of stocks.

But if you were planning to pull your money from the stock market in the near future, whether to make a big-ticket purchase, fund a college education or help pay retirement expenses, then if the market is showing more tendencies to fall, it might be the time to convert to less risky investments.

When the stock market takes a big hit, it's natural for investors to get scared.

Hopefully, the answers to these basic questions about investing in the stock market will let you decide, in a calm and reasonable way, what to do.

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Dr. Mike Walden is a William Neal Reynolds Professor and extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Posted by Dave at March 8, 2007 03:46 PM