There are many factors that impact the stock market, but they don’t need to sound complicated or full of jargon. Here’s a breakdown of some important terms that can help you understand what is affecting your portfolio and how.
Stocks
Stocks are units of ownership in a publicly traded company. When you buy stock, also known as shares, you essentially become part owner of that company. Shares trade on stock exchanges such as the New York Stock Exchange (NYSE) or Nasdaq, and you can buy and sell them in a brokerage account. When you invest in stocks, there are two ways you can make money. Stock prices fluctuate continuously, and one way to make a profit is by selling your shares if the price increases. The other way is by collecting dividends, which are a portion of earnings that some companies distribute to shareholders.
Nasdaq
The Nasdaq is the second largest stock and securities exchange in the world (behind the New York Stock Exchange). It became the first fully electronic stock market in 1971, which means it didn’t have a physical trading floor like the ones you see pictures of in the media.
S&P 500
The S&P 500 is a stock market index that tracks 500 publicly traded, large-cap U.S. companies. The index includes companies of different sizes and across different sectors, which is why it’s often used as a benchmark to measure the strength of the overall market. Investing in an S&P 500 index fund or exchange-traded fund is the simplest way to make a diversified investment. The S&P 500 has had a volatile year so far in 2022, with its worst start since 1970. Its seven-week losing streak, the longest since 2011, ended when the S&P 500 gained over 6.58% in the last week of May. But the index reversed gains the following week, ending the first week of June down 1.19%.
Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) or simply the Dow, is another stock market index and market indicator that is made up of stocks from 30 leading U.S. companies including Apple, Microsoft, Walt Disney, and JPMorgan Chase. It’s not the broadest measure of economic health because it consists of only 30 stocks, but it’s still important as a popular benchmark since its launch in 1896. The Dow also had a volatile month in May— an eight-week losing streak (its longest since 1923), including a drop of more than 1,000 points in a single day. Some of that pain was reversed when it gained 6.24% gain in the last week of May.
Bear Market
A bear market is when an index falls 20% or more from its most recent high over at least a two-month period. Bear markets are often caused by low levels of investor, consumer, and business confidence. Two of the major U.S. stock market indexes, the Nasdaq and the S&P 500, experienced bear markets in 2022. The Nasdaq fell 20.3% from its November high in March and the S&P 500 briefly entered bear market territory in May after declining more than 20% from its January high. So far in 2022, investors have been facing challenges such as the conflict in Ukraine, inflation, high interest rates, and rising gas prices, which have caused stocks to slide. A bear market rally is when stocks surge momentarily, but not enough to get out of the bear market, and come crashing down again. Bear market rallies are also sometimes known as a dead cat bounce.
Bull Market
Conversely, a bull market is when stock prices or indexes rise at least 20% over a two month period, and market sentiment is high. While investors expect prices to fall in a bear market, they expect prices to keep rising in a bull market. Remember, one way to profit from stocks is through price appreciation, so any expectation of increased stock prices means more investors buy stocks. That fuels more price increases. In a bull market, all three major indexes, the Nasdaq, S&P 500, and Dow Jones Industrial Average, rise at the same time. The most recent bull market was one of the longest in history—it lasted nearly 11 years from 2009 until it crashed at the start of the pandemic in March 2020.
Stock Market Correction
A stock market correction happens when the market falls 10% from its most recent 52-week high. Corrections are more common in a bull market and aren’t necessarily bad because the drop in prices allows investors to buy stocks at a lower price before they rise again. In a bull market, so-called irrational exuberance, a phrase first used by Alan Greenspan in 1996, can take over, leading people to believe stocks will just keep going up and creating a mismatch between prices and the underlying value of stocks. Corrections may occur due to this valuation mismatch or due to external factors leading to a decline in stock prices. When a correction happens those stock prices go back down to a more reasonable level. Bear markets are different from corrections because the declines are deeper and more prolonged in bear markets.
Bonds
Bonds are basically loans made to large organizations such as corporations, cities, and national governments. Generally, bonds pay a fixed interest payment, making them a predictable income producer for investors. Stocks and bonds tend to move in opposite directions. In a volatile market like the current one, investors often turn to bonds to keep their money safe and help offset more unpredictable stock holdings in their portfolios. But as investors pull money out of stocks and into bonds, stocks can decline further. When the market is doing well, bonds decrease in value because investors are putting their money in stocks instead.
Inflation
Inflation is the broad increase in the prices of goods and services over time—in other words, it’s the reason why essentials like food and gas are so expensive right now. Inflation decreases the dollar’s purchasing power, meaning you are paying more for less because your money doesn’t go as far. Inflation affects the stock market, too. Higher prices, especially for essentials, can leave less money for investors to put into stocks. On the other hand, inflation eats into corporate profits as companies struggle with higher costs, and that directly impacts stock prices. In May 2022, with inflation near a 40-year high, shares of Target, Walmart, and Dick’s Sporting Goods tumbled after the release of their earnings reports.
Monetary Policy
Monetary policy refers to the decisions made by a central bank—like the U.S.’s Federal Reserve—to manage economic growth, employment, and inflation. Fighting inflation is one of the Fed’s main priorities, and it does so by raising the benchmark federal funds rate, which makes borrowing more expensive for businesses and consumers and in turn, curbs inflation and slows economic growth. At the most recent Federal Open Market Committee (FOMC) meeting in May, the Fed raised the benchmark fed funds rate by a half percentage point to fight inflation, and promised two more rate hikes just like it. Rising interest rates affect stock markets in multiple ways. For one thing stocks become less attractive in terms of returns compared with other investments such as bonds. Higher interest rates mean lower prices for fixed rate bonds and higher bond yields. Secondly, higher interest rates mean higher costs for borrowing, which can impact company profits and affect both stock prices and dividends. An old investor saying, “Don’t fight the Fed,” suggests being more tactical in managing your investments and hedging your bets when the Fed raises rates.
