How Much Should Stock Prices Move?

Clients often tell us the stock market makes no sense to them. How can the value of a company fluctuate 10% in a day? How can an entire stock market index, representing hundreds of stocks, move on average 1% per day? Clients view this type of volatility as something more akin to a huge casino rather than a rational, efficient capital allocation mechanism. You know what? They are partially right.

One of my favorite studies was completed by Robert Shiller in 1981. It was called, “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends.” Its methodology was relatively simple. The true or intrinsic value of a company is equal to all the future dividends received from the company discounted at an appropriate rate. Since we do not know the future, determining intrinsic value of a stock is challenging. On the other hand, if we choose a point in time far enough in the past, we actually do know “future” cash flows. Shiller used this methodology to calculate the value of stocks in the S&P on an annual basis starting in 1870. He compared the calculated series (p*), which represents intrinsic value, to the market value (p). The following chart is from the paper:

Lo and behold he found that market value moved multiples (5 to 13 times) of intrinsic value. The market estimate of the value of the company was much more volatile than it should have been based on how a company’s cash flows changed in the future. Keep in mind his data set includes the Great Depression so you would have expected to see the fortunes of companies change dramatically (p* move up and down a lot) during this period, but they did not.

So, what is going on? After considering many rational explanations for the volatility, Shiller basically concluded that markets are not efficient and the movement in stock prices was irrational. Investor euphoria during bull markets drove stock prices above fundamental value. They assumed the good times would go on forever. Conversely, during bad times, they assumed markets would never recover and prices fell below fundamental value.

If prices move 14x more than they should, I will argue this does create an element of gambling or speculation in the short term. But, over the long term, markets return to their fair value as investors recognize their forecasts were overly optimistic or pessimistic. Maybe it does not need to be said, but this type of overreaction creates opportunities for an investor willing to rationally analyze the current environment and compare current prices to their estimate of fair value. This approach describes “value” investing, one of the most successful long-term investment strategies.

Shiller won the Nobel Prize in Economics in 2013 for his findings in this paper and many other contributions to the understanding of markets including his book “Irrational Exuberance” which predicted the 2000 Tech Bubble. The Tech Bubble was, up until now maybe, the best historical example of an irrational divergence from fair or intrinsic value.