Disentangling stock market moves

By now, the worst market sell-off since the Great Financial Crisis has been well documented and seared to investors’ memories. The root cause is well known – the economic fallout from locking down large parts of society to stem coronavirus. But this can be framed through different channels. Knowing which channel dominates helps us to navigate through these volatile times. In this week’s In Focus, we take a deeper look into the different drivers of market moves. 

How are stock prices determined?

Let’s start with the basics. According to standard finance theory, the price of the stock market is the sum of its discounted future cash flows(1). This means that the movements of stock market prices can be conveniently expressed as the sum of two effects: 1) Changing expectations of future cash flow growth, 2) The implied riskiness of being invested in the stock market (i.e. cost of capital, or discount rate applied to those expected cash flows). If investors think that future growth is going to be lower, or if they perceive the stock market has become a riskier place to invest (perhaps the expected cash flows haven’t changed but there is greater uncertainty around them), stock prices will fall, and vice versa. Unsurprisingly, both effects take place when the world is doing badly, whether it’s due to coronavirus or a recession. This is why stock markets do badly in such times. 

The problem

It’s an elegant theory, and it’s a simple framework for thinking about the relationship between the economy, investor behaviour, and stock market prices. The problem is that both growth expectations and the perceived riskiness of the stock market are unobservable. So if the stock market falls, we don’t actually know which of the two is driving it. Is it because growth expectations have fallen? Maybe investors have gotten more fearful? Or perhaps it’s a combination of the two?

How to think about growth forecasts

Many investors tend to focus on the first, usually using earnings forecasts from research analysts in investment banks to measure changing growth expectations. That’s not surprising – these research analysts spent their days doing specialist research to come up with forecasts for the specific stock they cover. However, even these analyst forecasts have limitations. For one, these analysts only do the research on specific stocks – they don’t actually take positions in the market(2). Therefore, their forecasts aren’t necessarily representative of the wider investment community’s own growth expectations. 

Besides that, it’s often been observed that consensus analyst forecasts tend to be overly-optimistic. They always start off being too high, before slowly getting revised downwards over time. We also observed that earnings revisions generally coincide or lag stock price movements. Large adjustments tend to cause analysts to revise their forecasts. This means that by the time analyst earnings forecasts have been revised, a lot of that information has been priced in already. These limitations make it difficult to use analyst forecasts as a timely or accurate gauge of investor growth expectations in real-time.

What about academic research?

While it’s impossible to obtain an accurate measure of both effects, a lot of interesting work has been done within academia itself that provide some useful clues. For example, it’s long been documented that most of the large-scale movements in stock market prices is due to changes in the implied riskiness of stock markets, rather than reduced earnings growth expectations(3). Simply put, stock market sell-offs are to a large degree caused by increased risk aversion, investors demanding a higher return for investing in stocks (i.e. the discount rate discussed earlier increases). This explanation fits nicely with the observation that large market sell-offs tend to be followed by higher returns. This historical pattern wouldn’t exist if stock market movements are mainly driven by lower future earnings. 

Another more recent paper uses a specific market instrument called dividend futures to obtain real-time estimates on how investors are pricing in the coronavirus growth shock(4). Dividend futures are publicly traded contracts that only pay out the dividends of a stock market index over a given time period. The prices on which they trade at are closely linked to investors’ expectations of future dividend growth. Using this information, researchers from the University of Chicago were able to back out real-time estimates of dividend and economic growth forecasts from investors. Their estimates show that during the March sell-off, investors had already priced in large declines in dividend and economic growth from the coronavirus pandemic. Note that this repricing already took place before any weakening in economic data was evident. This is in-line with the well-known observation that markets are forward-looking, in that they tend to incorporate slower growth prospects into stock prices well before they show up in actual data. 

This also explains why markets tend to rally before the data recovers. By the time the economy turns, markets would have already priced the recovery in. Investors who want to wait until the economy recovers before buying back into the market would have already been far too late. Interestingly enough, the researchers also found that the sell-off was also partly driven by a rise in the perceived riskiness of the stock market, which corroborates with the earlier academic findings. In short, the March sell-off was driven by both effects: lower growth expectations, and elevated investor risk aversion. The latter implies that there are indeed investment opportunities by investing in stocks during these times.  

Investor conclusion

There are a couple of lessons to be taken from these studies. The first is place less emphasis on consensus analyst forecasts when making investment decisions. Oftentimes, such forecasts tend to be priced into markets already by the time they reach us, especially when we observe sizable adjustments in asset prices in times of economic shocks. Finally, investors should have a bias to increase stock market exposure in market sell-offs like these. Both history and the academic findings show that times of fear and panic like these are the worst times to sell, but rather the best times to buy. 

We currently still hold a pro-risk stance within client portfolios, with our risk exposures spread out between equities, corporate credit, and emerging market debt. Although we have recently slightly trimmed this positive stance a bit, given markets have veered up materially in recent weeks.  

(1) In technical terms, the price level of the stock market is the sum of its future cash flow payments, discounted by the expected return demanded by investors as compensation for investing in stocks

(2) These analysts are employed by investment banks that act as research providers for investors. Their recommendations are sometimes followed, but not all the time. 

(3) Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? – Shiller (1981)

(4) Coronavirus: Impact on stock prices and growth expectations – Gormsen, Koijen (Mar 2020)

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