Business
Contextualization of the recent crazy stock market race
The wild turbulence in American stock prices recently is less frightening when we put it in a historical context and understand the factors that influence their values.
Most importantly, stock prices do not represent the value or stability of our economy. Stock market prices always vary more widely than the output of the economy. Since 2010, stock prices (measured by the Dow Jones industrial average, or DJIA) have quadrupled while the economy has grown by only 43%. Real wages during this period for many workers barely increased.
During the horrific recession of 2008-2009, stock prices fell by 50% while the economy contracted by 2%.
A look at the stock market crash of October 1987 provides an overview of the current functioning of the stock market. In one day (October 22), the market (still measured by the DJIA), fell 22.6%. This is the biggest drop in a day in the history of the New York Stock Exchange. Research on shareholder reaction to falling prices has revealed a significant difference between the behavior of individual shareholders (whom we know as investors) and fund managers (who make investment decisions for people who invest in their funds).
The majority of individual investors held their shares and waited for the market to rebound. Fund managers, however, did the opposite; they sold shares and contributed to the fall in share prices.
This distinction means that the models we use to value the stocks of companies seem to explain only the behavior of individual shareholders that we call investors. Fund managers seem to meet other criteria or motivations. These decision makers should not be viewed as investors by our traditional valuation models.
Since then, the funds have increased their share of common stocks and individual share ownership has dropped. Currently, the funds control approximately 75% of the common stocks traded on the US markets. This means that the individual shareholders, whose behavior we think we understand, only own a quarter. This is a factor contributing to the volatility of stock prices.
The second factor behind stock price variability is the role that expectations of future corporate earnings (dividends or cash flow) play in the models used to value stocks. Our valuation models clearly show that growth projections have a significant impact on the valuation of equities.
A share whose dividends are expected to grow by 5% in the future is valued at around 80% more than a share whose dividend is constant (often called preferred share), all other things being equal.
The variation in this expectation of growth, even slightly, therefore produces significantly different price valuations.
A reviewer could say that such growth projections are only guesswork and that no one really knows the future. That's right, but the market takes thousands of individual valuations based on different growth expectations, and the result is somewhere in the middle. However, this fails when someone or a group of stock buyers work together to monitor this interim valuation.
These expectations for future growth can be disrupted by unexpected events such as an epidemic. Even if growth projections are supposed to be long term, such disturbances throw the short term outlook into disarray. The result is that the future becomes more uncertain and all growth projections fall.
A slight drop in the projected growth leads the fund managers to reduce the valuation of their shares and, therefore, they sell shares that they had valued in the past.
Note that a decline in expected growth does not mean that the underlying economy is weakening in one way or another. Stock prices are falling while the output of the economy remains stable – further evidence that changes on Wall Street do not always reveal the underlying health of the economy.
This does not mean that a health problem like the current coronavirus does not directly affect certain businesses and industries. Analysts correctly adjust these values lower than the average company.
A related assessment factor is the risk of profitability of a business. All other things being equal, the higher the risk, the higher the rate of return required by investors and the lower the share price. Estimates of these risks are even less certain than a company's growth projections. A slight increase in perceived risk can lead to a fall in stock valuations, again regardless of the performance of the real economy.
The importance of growth projections may, however, play an even more important role in future debates about the nature and objectives of our economy. A growing number of environmental activists and economists advocate a sustainable economy, in which corporate profits are stable and are not expected to increase.
It is not difficult to imagine how such an economy would work. The road to get there would be more difficult if 50% (or much more) of our current market value is based on growth expectations.
Kenneth Zapp is Professor Emeritus at Metropolitan State University and mentor for SCORE (Service Corps of Retired Executives) Savannah.
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