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Disentangling stock market moves

What investors need to know

25 September 2020

6 minute read

The March sell-off was driven by both effects – lower growth expectations, and elevated investor risk aversion.

By now, the worst market sell-off since the Global Financial Crisis has been well documented and seared into 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 navigate through volatile times. This week, 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 flows1. 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 that 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 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 factors is driving it. Is it because growth expectations have fallen? Maybe investors have become 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 market2. 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 observe that earnings revisions generally coincide with or lag behind 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 expectations3. 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 were 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 shock4. 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 (Figures 1 and 2). 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.

Figure 1: Investors priced in dividend cuts as markets fell

During the March sell-off, investors priced in large declines in dividends from the coronavirus pandemic

Source: Bloomberg, Barclays

Figure 2: Growth estimates also fell sharply

During the March sell-off, investors priced in large declines in economic growth from the coronavirus pandemic before it could be seen in the data

Source: Bloomberg, Barclays

This also explains why markets recovered before the data. 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 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.

Investment 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 sizeable adjustments in asset prices during times of economic shocks. Finally, investors should have a bias to increase stock market exposure in market sell-offs like these. Both history and academic findings show that times of fear and panic like these aren’t just the worst times to sell, but also the best times to buy.

Things to consider

The value of investments can fall as well as rise. You may get back less than what you originally invested.

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