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Should Investors Fear Market Volatility?

With company cash flows hard to forecast, volatile share prices are a rational response to stock market risk and uncertainty

Alex Bryan 04/09/18

Stock market volatility

Investors often overreact to macroeconomic news, not properly evaluating their impact on a company’s future cash flows, which can create opportunities for value investors. Nobel Laureate Robert Shiller made a similar argument that market prices are more volatile than they should be, based on changes in future dividends.

While the market probably doesn’t always get prices right, a look at historical earnings suggests that the volatility in share prices is justified on average. A share’s intrinsic value is the present value of its future cash flows plus whatever assets it has minus liabilities. These cash flows are risky because they represent the cash that is left over at each firm after all the bills are paid. Given the large impact of cash flows on fundamental value, it might seem like stock prices should be roughly as volatile as their firms’ cash flows. But investors don’t know what those cash flows will be ahead of time and that uncertainty is a source of added volatility.

Stock prices reflect the market’s best estimate of what each firm’s future cash flows will be, and those estimates change over time. But uncertainty around those estimates can change too, which influences the discount rate investors use to discount those cash flows. This the compensation investors require for equity risk, known as the equity risk premium.

Investors require greater compensation for risk during contractionary periods in the business cycle and less compensation when business is good. Share prices fall more than their earnings during bad times and rise more than earnings when times are good, magnifying stock volatility relative to earnings.

Cash Flows Are Hard to Spin

According to Morningstar data, from the end of 1969 to the end of June 2018, share price returns in the US and foreign developed markets have been a bit more volatile than earnings.

Earnings can be more easily managed than cash flows. Managers can change some of their accounting choices to report higher or lower earnings. This can either induce a smoothing effect, where managers seek to mitigate the apparent volatility in their business, or cause earnings to appear more volatile than cash flows. Managers may be tempted to recognise all the bad things together when they are already going to miss expectations – and become increasingly aggressive with their accounting assumptions to keep up with or beat analysts’ expectations when times are good. That said, earnings should be a decent proxy for cash flow for the market as a whole.

Why Share Prices Overshoot

It isn’t surprising that market prices have been a little more volatile than earnings because investors don’t know what future earnings will be and the compensation they require for that risk changes over time. Future cash flows are unknown. But it is possible to infer how investors have historically dealt with that uncertainty by looking at the data.

Not surprisingly, share price discounts tended to increase during market downturns, like in the early 2000s and during the 2008 financial crisis, and decrease during market rallies. These fluctuations aren’t clearly irrational: they reflect changes in the level of risk in the market and investors’ willingness to bear that risk.

Think back to the financial crisis. With share prices tumbling, did you take risk off the table as expected returns climbed? Do you feel more comfortable with risk now that the market feels less scary and expected returns are lower? If so, you’ve got company.

Fear and greed contribute to market volatility. They may create opportunities for investors who require a different amount of compensation for risk than the market, but market volatility is not irrational, and it does not serve up free lunches. Rather, market volatility reflects changes in stocks’ fundamental value in the presence of uncertainty. The market isn’t crazy after all.

About Author Alex Bryan

Alex Bryan  

Alex Bryan is the Director of passive fund research with Morningstar.