Why Should Economic Developments Affect Stock Prices?


Valuation-Informed Indexing #174

by Rob Bennett

You are a rational investor.

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You have looked at the historical return data and seen that the U.S. market has for 140 years delivered to investors an average long-term return of 6.5 percent real. That sounds good to you. So you invest a percentage of your portfolio in stocks consistent with an expectation that that will be the return on a going-forward basis.

Then something happens.

There is good economic news. Perhaps a report that a sustained recovery is on the way. Does that cause you to increase your stock allocation, thereby pulling prices up a bit?

The Buy-and-Hold Model says that it does. It says that prices go up or down in response to unforeseen economic political developments. When investors hear good news, prices rise. When investors hear bad news, prices fall.

Does that really make sense?

I don’t think so.

Any investor who bought stocks expecting a long-term return of 6.5 percent knew when she did so that there were going to be positive economic developments during the time-period in which she held her stocks. So why should she be impressed that the recovery was picking up steam? She expected something like that to happen all along. Didn’t she?

So it’s not news. It’s not cause for excitement about where stock prices are headed. It’s not a positive development. It’s a development entirely consistent with the understanding on which the stocks were purchased in the first place. So it shouldn’t cause prices to rise.

The same observation is of course true regarding price movements in the opposite direction. Say that there is news that the economy might fall back into recession. Buy-and-Holders say that news of that sort is what causes prices to fall. But why would it? Investors understood when they made their investing decisions that there would be some bad news mixed in with the good. They knew that there was a chance that we would fall into another recession. So there should be no negative reaction to that news.

The idea that prices rise and fall in response to unforeseen economic and political developments is rooted in a belief that investors calculate the discounted value of future earnings and set stock prices accordingly. That idea makes sense. But why would we classify reports of a recovery or of a fall into a second recession as “unanticipated”? Investors knew that these were possibilities all along and presumably incorporated the effect of these possibilities into their initial calculations. So there is no need for price adjustments when one of the possibilities comes through as the actual real-world event.

I of course understand that this analysis is exceedingly theoretical. No one really knows what goes on in the minds of investors when they set their stock allocations or when they revise them. We’re talking about angels-on-the-head-of-a-pin stuff. What’s the practical value of such a discussion?

The practical value is that this way of looking at things may cause you to experience doubts about another angels-on-the-head-of-a-pin way of looking at things. I cannot offer concrete proof that my way of thinking about how investors set stock prices is the right one. But the Buy-and-Holders cannot offer concrete proof that their way of thinking about how investors set stock prices is the right one either. My aim is to suggest that we don’t know as much as we think we know and thereby to open your mind to an alternate possibility.

Actually, there is one bit of concrete proof that I can offer in support of my way of understanding things. The 140 years of historical return data available to us today.

If the Buy-and-Hold understanding were the correct one, price changes would be random. By definition, there can be no sustained pattern to unforeseen economic and political changes. Changes that are truly unforeseen should fall out of the sky to the surprise of all concerned. That’ why the title of the famous book is “A Random Walk Down Wall Street.”

But never once have long-term returns ever played out in a random manner.

Never once.

For 140 years now, we have seen returns play out in the manner in which we should expect them to play out if they were being determined not by unforeseen economic and political events but by the ups and downs of investor emotions.

That’s what I think the driver is here.

Economic and political developments play a secondary role. Good economic news can cause pent-up positive investor emotions to evidence themselves in upward moving stock prices. And bad economic news can cause pent-up negative investor emotions to evidence themselves in downward moving stock prices.

But please note that there is all the difference in the world between saying that economic news plays a primary role in setting prices and saying that economic news plays a secondary role in setting prices. If emotion is the driver, even slightly positive news can cause huge price gains and even slightly negative news can cause huge price drops.

The idea that it is unforeseen economic and political developments that cause stock price changes is a theory. It is not something that has ever been proven. In fact, the historical record points the other way. The historical record argues strongly that we should be searching for new and improved understandings of the causes of stock price changes.

Rob Bennett has recorded a podcast titled My Conversations with Michael Kitces. His bio is here. 

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