A reader wants to know how market corrections work, why certain stocks fall more than others, who is selling and why some stocks bounce back first.

Stock markets involve buyers and sellers making transactions based on expectations for what might happen to a business. The price will fall if more people want to sell a stock than buy.

Equity ratings also play a role in the level of share price decline. Let’s say the coronavirus crisis causes two different companies to suffer the same amount of decline to earnings. In this situation, something trading on 30 times forecast earnings is likely to fall by a greater amount than something on 10 times earnings.

For example, Company X might be trading at 200p, which is 10 times the 20p earnings per share it is forecast to make. If the market believes those earnings will drop by 25% to 15p, to maintain a price-to-earnings ratio of 10 the stock would, in theory, drop to 150p.

However, let’s say Company Y is trading at 600p, which is 30 times the 20p EPS it is forecast to make. To reflect the same 25% drop in earnings, investors would effectively sell down to 450p assuming it still commanded a PE of 30.

In reality, investors may no longer be prepared to pay a premium rating, so it might de-rate to a PE of 20. Doing the maths (20 x 15), it would, in theory, trade at 300p – so its share price has halved versus a 25% drop for Company X.

Expectations were already low for Company X, given it was on a PE of 10, so there is a chance it doesn’t de-rate beyond adjusting for lower earnings.

You also need to consider how the market would view a company in the current situation. Tesco (TSCO), for example, has held up better than Associated British Foods (ABF), because its shops are still open and demand is high. The latter owns Primark whose shops are shut, thus a chunk of its revenue has disappeared overnight. Of the two, Tesco might be seen as more attractive to investors and therefore command a higher rating. This is not the case at the moment so one has to consider if Tesco is underpriced or ABF overpriced.

It is impossible to say exactly who is selling the shares in a correction, apart from to say institutional investors must report if their positions above a certain level have changed.

In reality it could be a wide range of investors. Fund managers might have been forced to sell if their clients asked for their cash back. Retail investors might have sold if they were scared.

Traders – both institutional and retail – might short-sell certain stocks if they believe they will fall in price, as that would give them a profit. The FCA publishes a daily list revealing the institutions shorting stocks.

Leisure and oil stocks have been rallying hard following the big sell-off last month. That’s because many of them were priced to go bust. Airlines are now getting government loans, investors are becoming more optimistic about the crisis being resolved soon, and oil prices have started to pick up. Therefore investors are reappraising these sectors, hence why their shares are shooting back up again. The big question is how long this recovery rally will last.

Readers should email any further questions about the market to editorial@sharesmagazine.co.uk and we’ll do our best to respond in a future issue of Shares.

‹ Previous2020-04-16Next ›