Putting the stock market's recent wild ride in context

The wild turbulence of American stock market prices recently is less scary when we put it in a historical context and we understand the factors which influence their values.

Most important, the stock market prices do not represent the value or stability of our economy. Stock market prices always vary more widely than the output of the economy. Since 2010 stock prices (measured by the Dow Jones industrial average, or DJIA) have quadrupled while the economy has grown only 43%. Real wages during this period for many workers have barely increased.

During the horrible recession of 2008-09, stock prices fell by 50% while the economy shrunk by 2%.

A look at the stock market crash of October 1987 provides insight into how the stock market currently operates. In one day (Oct. 22), the market (again measured by the DJIA), fell 22.6%. This was the largest one-day decline in the history of the New York Stock Exchange. Research on how shareholders reacted to the fall of prices revealed a significant difference between the behavior of individual shareholders (who we know as investors) and the fund managers (who make investment decisions for people who invest in their funds).

The majority of individual investors held their shares and waited for the market to rebound. Fund managers, however, did the opposite; they sold shares and contributed to the drop in stock prices.

This distinction means that the models we use to value corporate shares seem to explain only the behavior of individual shareholders whom we call investors. Fund managers seem to respond to other criteria or motivations. These decisionmakers should not be considered investors by our traditional valuation models.

Since then, the funds have increased their share of common stock ownership and individual ownership of shares has fallen. Currently, funds control about 75% of common stocks traded on American markets. This means that individual shareholders, whose behavior we think we understand, own only one-quarter. This is one factor contributing to share price volatility.

A share whose dividends are expected to grow 5% into the future is valued about 80% higher than a share whose dividend is constant (often called a preferred stock), all things being equal.

Varying this growth expectation, even slightly, therefore produces significantly different share price valuations.

A critic could say that such growth projections are just guesses and that no one really knows the future. This is fair, but the market takes thousands of individual valuations based on different growth expectations, and the result is somewhere in the middle. This fails, however, when someone or a group of stock buyers work in concert to control that middle valuation.

These expectations of future growth can be disrupted by unexpected events such as an epidemic. Even though the growth projections are intended to be long-term, such disruptions throw short-term prospects into disarray. The result is that the future becomes more uncertain and all growth projections fall.

A small drop in the projected growth causes fund managers to reduce their share valuations and therefore they sell shares they had valued higher in the past.

This does not mean that a health challenge such as the current coronavirus does not negatively affect some firms and industries directly. Analysts correctly adjust these values down further than the average corporation.

A related valuation factor is the riskiness of a firm's profitability. All things being equal, the higher the risk, the higher rate of return investors require and the lower the stock price. Estimates of these risks is even less certain than a firm's growth projections. A small increase in perceived risk can cause share valuations to fall, again independent of the performance of the real economy.

The importance of growth projections, however, can have an even more important role in future debates about the nature and goals of our economy. A growing number of environmental activists and economists advocate a sustainable economy, one in which corporate profits would be stable, not expected to grow.

It is not difficult to imagine how such an economy would function. More challenging would be the road to get there if 50% (or much more) of our current stock market value is based on growth expectations.