I had a discussion with someone about the recent stock market decline and he observed that despite the drop in stock prices, corporations seemed to be healthy and were still making lots of profits. He then said: “That’s what I don’t get. How can the market go down so far and so fast, when nothing has changed? The market seems rigged!”
It’s an understandable sentiment given the recent market volatility. During the three weeks from December 3rd, 2018 to December 24th, the S&P 500 declined by more than 15%! Yet, if you walked into a WalMart, a McDonalds or a Starbucks at the end of December, things didn’t look much different than they did the month before. By all accounts, it’s business as usual. Yet, the market says that the companies of the world are worth 15% less than they were worth just last month. How is this possible?
To answer this question, we first need to consider what exactly we are buying when we buy a stock. When you purchase stock in a company, you are purchasing a share in its future earnings, and these earnings, by their very nature, are highly uncertain. Unlike a CD or a bond, a stock offers no regularly scheduled interest payments and no promises to repay at a specific maturity date. It is this uncertainty that is the source of the volatility we see in stocks.
Here is an example using a standard stock valuation model. To estimate the value of a stock, we first estimate future earnings, and then we apply a discount rate to these earnings. The purpose of the discount rate is to adjust the earnings estimate for both timing and uncertainty.
Let’s assume a particular stock will earn $1/share in 2019, and that those earnings will grow by 3.5% per year indefinitely into the future. Next, we apply a discount rate of 7% to those earnings (the 2% risk-free rate as measured by the 10 year Treasury plus a 5% equity risk premium (ERP) factor). Based on those assumptions, the valuation model implies a fair value stock price of approximately $28.5/share.
Now, let’s assume that the company announces a downward revision in its earnings estimate for next year to $0.90/share. Even if we assume that earnings will still grow at 3.5% from there on out, the stock price estimate using our valuation model drops to $25, a 12% decline.
Now let’s assume that the earnings estimate remains unchanged, but the perceived riskiness of those earnings increases. In other words, we don’t think earnings will decline, but we are not as sure as we used to be. As a result, a higher discount rate is justified. If the discount rate we apply to the future earnings is increased from 7% to 8%, the implied stock price drops to $22/share, a decline of 23%.
And what if we assume both a downward revision in the earnings estimate and an increase in the discount rate? Under that scenario, the implied stock price is $19/share, more than a 30% drop in price.
So as you can see, the value of a stock is very sensitive to small changes in the assumptions we use to value a stock. That is why stocks can drop and drop very quickly (or go up very quickly), even if it appears as if nothing has fundamentally changed. And the same is true not just with individual stocks, but also with the market as a whole.
So, why in the world would anyone want to own stocks? Well, no one would, if it wasn’t for one important thing: While there are no guarantees, investors can reasonably expect to get paid a higher return over time for owning stocks than they are likely to get from owning a bank CD or a Treasury bond. The higher return is compensation for taking on the additional risk, volatility and uncertainty of owning stocks. Take away that risk, and you take away those potentially higher returns.