Why Did Stocks Abruptly Fall? –There Are Only Two Reasons
[Disclaimer: The chart and the following content do not constitute investment advice of any kind. This material is for educational or entertainment purposes only. ]
(SPX Chart from www.bigcharts.com retrieved Nov.20, 2018)
THE OCTOBER WIND BLEW all the leaves off the Wisconsin trees last month and did it over the course of only a few very windy days. Stock prices drifted ten percent lower, too, in recent weeks and everyone wants to know what chill wind sent them lower.
The point of this lesson is that the stock market has changed its mind and is making a new forecast. The price of any financial asset is derived from the future–not the past.
I can explain the “why” because there are only two reasons stocks fall. The details are harder to derive.
I have never been able to talk about the investing environment without providing some background. No forecasters (I do not act as a forecaster here) worth their salt would fail to explain their position. Some background:
In terms you will never hear your stockbroker or adviser use, there are only two things that ultimately determine stock prices:
1) the size and timing of expected future cashflows (read ‘earnings or dividends’) and
2) the discount rate or Time Value of Money (TVM) used to translate those future cashflows into present terms or simply “today’s price.” [Note: this rate is also the required return on investment. Investors increase their potential return by insisting on paying a lower price. Thus the higher the discount rate, the lower the price of the investment.]
That’s it: pure financial theory.
But those two items (alone or in combination) explain everything that occurred in the last few weeks. The market has fallen sharply so either:
- Estimates of future cashflows were reduced due to a conglomeration of factors: recession fears, trade wars, domestic or geo-political concerns, or even climate disruption
- Discount rates could have risen because interest rates may be projected to rise further or due to greater uncertainty (risk) with regard to the above cashflows
Let’s use a real-world example.
The S&P500 index serves as a proxy for “the market” (NYSE:SPX). About one month ago, it reached a high of 2930. Earnings had been projected to be about $178 per share next year and were estimated to grow at 20% per year thereafter. Using a spreadsheet out to 12 years. I ran two sets of calculations for the S&P500:
- In order to assess the impact of changes in cashflow estimates, I ran the first set of calculations assuming the index earnings would only grow at 15% per year instead 20%. The result (using a discount rate of 13.5%) was an index price of about 2500, a 16% percent drop from the high.
- To assess the effect of an increase in the discount rate in addition to the lowered cashflow estimates, I assumed a 16.5% TVM (instead of 13.5%) for the scenario above The resulting new price was about 2400 for the index.
My crude experiment was designed to demonstrate how the combination of a 5% decrease in future earnings growth estimates and a 3% increase in the discount rate (TVM) could result in a theoretical price drop of almost 27%. As of this writing, the index has only fallen 10% from the high. Will it continue down? –That will depend upon expectations for interest rates and/or economic conditions for corporate earnings.
The point of this lesson is that the stock market has changed its mind and is making a new forecast. The price of any financial asset is derived from the future–not the past. Thus, stock prices are delivering a message: interest rates could continue to rise, and/or the future earnings of these large companies are not as robust as once thought. The specific catalysts and causes of these adjustments to price are not clear, but one thing is clear: in only the last few weeks, a lot of investors recalibrated their gauges of future economic conditions.