Whenever the stock market falls, people wonder why it’s happening.
There are always lots of creative stories, and they’re probably right to some degree, but the reality is that the stock market is like a mutating organism whose changing mutations have ever-changing causes. We don’t really know what causes it to change each time, and we can’t necessarily use past understandings to predict future changes. Still, we make up these narratives because they give us the illusion of control in an otherwise opaque world.
Despite all these ebbs and flows, there is, at its core, a fundamental reason why the stock market rises and falls, and this story will help you better understand how to respond to the market’s inevitable gyrations.
Also by Cullen Roche: ‘Don’t panic’ is probably the worst thing you can say to an investor
The stock market, as represented by the Dow Jones Industrial Average DJIA, -2.16% or the S&P 500 Index SPX, -2.86% reflects the corporate actions of its underlying entities. The price changes reflect the expected future cash flows that these entities will generate. So, for instance, if the stock market were comprised of one super-high-quality stock that paid out all of its earnings in the form of a dividend of 10%, then we could reasonably expect that stock to earn 10% every year. Any price changes along the way would be due to exogenous factors, but we can reasonably predict that any annual returns that deviate too sharply from 10% are irrational, since the underlying entity literally cannot pay more than 10% in cash flows per year.
Of course, that’s not how reality works, but it’s a decent starting point. In reality, stocks earn their returns from three primary sources:
1. Earnings yield (how much a corporation earns in per-share profits).
2. Dividend yield (how much a corporation pays in profits-per-share).
3. Multiple expansion (how much someone is willing to pay per-share for a dollar of earnings).
If the stock market generates 7% in earnings per share growth and 3% in dividends, it is reasonable to expect that the total return of the stock market will be 10%. Interestingly, profits and dividends are fairly stable over very long periods of time. The stock market is, in effect, a lot like a super-high-quality, long-maturity bond.
Of course, we don’t really know what future profits or dividends will look like even if the past gives us some idea. We also don’t know how much multiples will ebb and flow because we can’t predict how much an irrational group of apes will pay for a future dollar of earnings. And most importantly, while it’s reasonable to expect profits and dividends to grow in the long term, we have zero idea how those cash flows will materialize in the short term, and the short term is where most of us live our financial lives.
So we can arrive at two relatively simple answers based on these understandings:
1. Why does the stock market rise? It rises because in the long term it is reasonable to expect that corporate profits, earnings per share and dividends will rise.
2. Why does the stock market fall? It falls because in the short term the cash flows that corporations earn are uncertain and that leads multiples and prices to gyrate.
This is what makes the stock market so risky for most people — we have short-term liabilities that the stock market cannot reliably match. The problem is, most people want the high long-term return from No. 1, but don’t want the short-term risk involved in No. 2.
The important point is, there’s no cure-all for this. The best we can do is understand the inherent mismatch between No. 1 and No. 2, allocate our assets so they don’t expose us to excessive behavioral risk from No. 2 and remember that only time can resolve the uncertainty of No. 1.