Why Does The Stock Market Rise And Fall? -

Why Does The Stock Market Rise And Fall?

Oct 25, 2018Jeremy ParkinsonFinance, No picture0

Whenever the 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 markets inevitable gyrations.

The stock market 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 was 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.