The Chicken & The Egg
By Conner W. Mays
A few days ago, I opened The Wall Street Journal’s Daily Shot, a newsletter that covers nearly every corner of the economic/market environment. The headline “The Economy and Stock Market Divergence” grabbed my attention. Firstly, contrary to popular belief, the economy and the market are two separate things, the two terms, as I see and use them:
The Economy – The cash generating potential of the labor force and the amount of cash that ends up actually being generated by businesses, governments, individuals, etc…
The Market – A medium where investors and traders buy & sell investment vehicles in an attempt to profit from volatility in the market value of various investment vehicles.
The Chicken & The Egg
We can have the same argument between economic growth and market returns but our question is slightly different – “Do market returns drive economic growth, or does economic growth drive market returns?” Fortunately, we have slightly more clarity into the relationship between market returns and economic growth, as opposed to the arrival of the chicken & the egg. Unfortunately, an exhaustive derivation of the relationship between the two would be quite technical and requires the use of a few different economic theories and that isn’t why we’re here so let’s just take a look at the chart below:
The change in market value (returns) of The S&P 500, an equity index of 500 constituent securities, represented by the black line. Earnings and dividends (cash flows) growth produced by the constituent securities of The S&P 500, is represented by the blue line and the red dotted line represents Wall Street’s expectations of future earnings and dividends (cash flows) growth.
The fundamental or intrinsic value of a financial asset is the sum of its future cash flows (earnings and dividends) discounted back to today. In theory, the fundamental value of a stock is what a buyer should be willing to pay today for a stream of future cash flows. Thus, we would expect the black line, to exhibit positive correlation, or move in the same direction and closely follow, relative to the blue line. As you can see, most of the time, the relationship between market returns and earnings and dividend growth holds, meaning the variation of returns follows variation of the growth rate of cash flows. However, there are periods where the relationship fails to hold.
The intuition here is where the returns diverge or deviate from earnings and dividend growth, market value deviates from fundamental value.
Why should you care?
Historically, market returns have exhibited characteristics that lead us to believe a mean-reverting level exists and is related to growth in an asset’s corresponding cash flows. Observing returns from 2000-2003 (Tech Bubble) and 2007-2009 (Great Financial Crisis) we can see that deviations tend to revert back to the norm quite harshly. In the years preceding these periods, returns exceeded earnings and dividend growth by a wide margin. Fast forward to today, returns have exceeded the growth in cash flows by wider margins for a longer period of time than they ever have. History shows us this divergence can’t go on forever, implying one of two things must happen:
- Returns will revert back to their normal levels (via negative returns aka losses) relative to growth in cash flows.
- The growth rate of cash flows must increase enough to catch up to the market values.
There are a number of things that can explain this divergence. From 1996-2000 the market believed this new awesome thing, the internet and more specifically e-commerce, would change economic fundamentals enough that future earnings growth would increase sufficiently to satisfy market values, which didn’t work out so well. From 2003-2007 the market was juiced up by excess leverage, once the housing crisis arrived, the party was over, the stream of leverage was cut-off and market values fell back to and in some cases even below fundamental value in spectacular fashion. Following the Great Financial Crisis, the world’s central banks came up with Quantitative Easing in an effort to induce The Wealth Effect.
Quantitative Easing (QE) is the policy of purchasing government bonds from banks using electronic cash which did not exist before to increase bank reserves and the money supply. Higher reserves make it easier for banks to originate loans at lower interest rates which stimulates economic growth and thus, growth in earnings and dividends which leads to increased market values.
The Wealth Effect ascertains when investors see their portfolio’s market value increase, they feel more financial security and spend more today instead of saving for future consumption. Increased levels of current consumption lead to increased growth rates of cash flows which increases the growth rate of market values. (Hint: chicken & the egg)
Quantitative Easing and The Wealth Effect distort the idea that the growth rate of cash flows is one of the primary drivers of market value. The Wealth Effect uses increased market values to induce increases in economic growth (aka growth rate of cash flows.) Drastic times call for drastic measures and the Great Financial Crisis certainly qualified as a drastic time and Quantitative Easing certainly qualifies as a drastic measure.
Fast forward to today, The US central bank, The Federal Reserve, has stopped its Quantitative Easing policy and has started increasing interest rates. However, market values continue to churn higher based on hopes of economic growth from organic sources and more business friendly policies out of Washington, both of which have yet to materialize, but the party (increasing market values) can’t last forever. Only time will tell if market values will fall back to fundamental levels or if earnings and dividend growth will increase enough to satisfy the current level of market values.
I am not calling a top and/or suggesting a crisis is around the corner however, there are a number of risk factors in the market that require the attention of every investor.
If you have any questions / comments or general topics you would like me to discuss please let me know. Shoot me an e-mail at email@example.com
Thanks for reading!
I wrote this article myself, it expresses my own personal beliefs and opinions.