Interesting work by Dan Greenwald, Martin Lettau and Sydney Ludvigson on what moves the market.
There is little mystery that the real value of the stock market drifts upward over long periods in a largely predictable way as productivity (driven by technological progress) improves. This same deterministic trend has also propelled output per capita and the average standard of living upward over the last several centuries. It is instead the random shocks, the boom and busts around this trend, about which we have little knowledge, yet on which a continuous stream of media speculation centres. Such random shocks can persistently displace the market from its long-term trend for periods as long as several decades. What drives these movements in the market?
They identify 3 types of shocks that account for market fluctuations around the long-term trend:
- Productivity shocks which increase total output relative to inputs
- Factor shocks which increase/decrease the share of output paid to workers
- Changes in investor risk tolerance which affect their willingness to hold stocks.
For example a company may experience a surge in output through improved technology. The share of increased earnings paid to workers will determine the level of profits remaining for distribution to shareholders. I illustrated this recently in a graph of the inverse relationship between employee compensation and corporate profits as a percentage of value added.
The current “Grexit” turmoil is an example of the third factor, investor risk tolerance, where output and factor shares are unaffected but investor willingness to hold stocks decreases. The increased risk premium demanded causes market valuations to fall while earnings are unaffected.
….We find that these shocks explain the vast majority (87%) of fluctuations in quarterly stock wealth growth, implying that we can decompose almost all of the variation in the US stock market into components corresponding to these three sources of economic variation. We find that:
When we measure variation in the stock market over short to intermediate horizons (i.e. over months, quarters and business cycle frequencies), fluctuations in stock market growth are dominated by shocks to risk tolerance that have no discernible effect on the real economy.
Over longer horizons (i.e., over years and decades), 40-50% of the variation in stock wealth growth can be attributed to factors share shocks–those that move the stock market in one direction and labour income in the other.
Shocks to productive technology have a very small effect on fluctuations in stock prices at all horizons.
This does not mean that we should ignore market valuation. High earnings multiples are more prone to shocks than low ones. But we can ignore secondary influences on risk premiums — I call them “media corrections” — caused by market noise. The study also confirms that fluctuations in factor shares (or profits as a percentage of value added) can last for more than a decade; so reversion of US profit margins to the mean may take some time.