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After all, markets don’t make big moves without a reason.
Investors often look for catalysts that might take the market on its next major move, up or down. When reviewing an analyst upgrade or downgrade or when reading internet articles describing the stock market, the term ‘catalyst’ is used frequently – but beginners may not be familiar with what catalyst means or how it is used. A catalyst is a dramatic event that can move markets. It goes without saying that a market-moving event must be notable, as the stock market is comprised of thousands of publicly-traded companies, worth trillions of dollars. When the markets climb or fall by large percentages, there is a reason for those movements and the reason is called a catalyst.
But there are indeed many events that can move markets in either direction and in the short-term or the long-term. Investors should familiarize their understanding of market catalysts and how they have the potential to move stock markets.
Catalysts can serve a very valuable purpose, which is to correct significant undervaluation or overvaluation of stocks. If a company has seen its stock price decline by a large amount, unveiling a new product or pursuing a merger can serve as a catalyst to bring the valuation back in line with more appropriate multiples. These catalysts can take effect both in the short-term or the long-term.
For example, a short term catalyst could be monthly job reports. Each month, the Bureau of Labor Statistics releases a report that details how many jobs were created in the preceding month, along with the new U.S. unemployment rate. Every monthly report can have a tangible effect on the market, as investors infer the health of the underlying U.S. economy based on the signals sent by the labor market. However, this effect is usually not long lasting, as it will only be 30 days until the next month’s report, which could send a whole new batch of signals.
An example of a market catalyst that had only a short-term impact on the stock market was the May 2016 jobs report, which showed that 38,000 new jobs were created, falling well short of the 162,000 expected by economists. This news caused the Dow Jones Industrial Average to fall nearly 150 points at the open on the day the disappointing jobs report was released, but this only proved short-term. Future jobs reports in subsequent months strongly beat expectations, and the markets have since recovered to climb near all-time highs.
On the other hand, catalysts can be long-term in nature. An example of this is interest rates. The U.S. Federal Reserve convenes a few times each year to discuss the state of the U.S. economy and make decisions regarding whether interest rates should be changed or remain the same. In December 2015, the Federal Reserve raised interest rates, measured by the Fed Funds Rate, from zero to 0.25%. This was the first interest rate increase in nearly a decade and, as a result, had a significant impact on the markets that is still reverberating. What happens to interest rates can affect a number of market sectors on a long-term basis, including utilities and real estate investment trusts (REITs). These companies can have their long-term capital structures impacted by changes in interest rates.
Another example of a market-moving catalyst with long-term implications is the recent Brexit vote. On June 23, Britain voted to leave the European Union. This was a notable event that caused global markets to decline significantly. While global indexes have recovered, there are many well-known dividend stocks that have not recovered. For example, utility giant PPL Corp. (PPL ) was trading at $39.44 per share on the day of the Brexit vote. PPL is highly exposed to the Brexit because it generates a significant portion of its revenue from Europe – which most economists agree is seeing economic growth decline because of Brexit. PPL stock has declined 12% since the Brexit vote.
Among different investor groups, not all may place a high priority on understanding market catalysts. For example, value investors typically focus on the intrinsic value of a company in relation to where the stock is currently trading. This is the style of investing in which legendary investor Warren Buffett subscribes. Value investors are concerned with finding stocks worth more than their current market price – and are not as focused on market catalysts.
However, dividend investors may see merit in analyzing market catalysts. The dividend yield is one of the most valuable metrics for dividend investors. It expresses a company’s annualized dividend as a percentage of a stock price. Since the dividend yield is a function of stock price, a rising stock price reduces dividend yield, and vice-versa. As a result, dividend investors should pay attention to potential market catalysts moving forward, as big moves in stock prices will cause dividend yields to fluctuate, thereby impacting a dividend investor’s decision. Dividend investors are interested in market catalysts because they can influence entry or exit decisions.
Market events are not always interpreted in terms of potential catalysts, but catalysts are an important aspect of stock market investing. Ultimately, all investors should care about market catalysts, and be able to notice when catalysts happen and how they can shape the stock market, both in the near-term or for longer periods of time. Changes in interest rates can have an impact on REITs and utilities for years. Investing in sectors that are dictated by catalysts requires an understanding of potential catalysts moving forward.
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