The key objective of any investor is to get more than one dollar back for every dollar invested. Sadly, most introductory investment courses and literature do not begin with an explanation as to why stocks go up. It’s such a fundamental question, but often overlooked.
Stock prices rise because of two factors – growth in earnings and expectations for future growth. They may sound like the same thing, but expectations for future growth is very subjective, whereas growth in earnings is empirically measurable.
What drives these two factors? Earnings growth is easily explained. As the economy grows, companies prosper and earnings increase. Simple and straight forward. However, explaining expectations for future growth isn’t as straightforward and requires that we make assumptions about the future and how other investors will behave. Stocks, and therefore the stock market, are driven more by expectations and the change in variables that affect expectations than actual measurable earnings. That is why we see wide swings in prices as we did in the fourth quarter of 2018.
The S&P 500 Index set a new all-time high on October 3, 2018 and then proceeded to decline 20% over the next three months. What changed? The expectation of future growth was affected by investor’s perceptions that the economy was slowing, that the Federal Reserve was going to continue increasing interest rates, and that trade negotiations between the U.S. and China were going to continue to make imports more expensive and slow global trade. What happened to earnings during those three months? Nothing. There were some companies that forecasted softer growth for 2019, but those forecasts are based on extrapolating the current environment continuing.
The value of the stock market at any given time is the combination of these two factors, reported earnings that will likely grow and compound into the future because of growth in the population and economy, and a subjective assumption of how the future will unfold. The volatility in the stock market results from investors changing their view of the future and revaluing stock prices based on new information.