What Drives The Stock Market

My recent post, Nah…you just ain’t seein’ the ball addresses the lazy confession you hear when professional investors moan “the market doesn’t care about fundamentals”.

At the end of that post, I pointed to research that shows that in the long-run fundamentals remain the largest driver of returns.

• Total Shareholder Return Linking The Drivers of Total Returns to Fundamentals by Michael Mauboussin
• Pods, Passive Flows, and Punters by Drew Dickson

Good businesses pay off. While the wrong price can ruin any investment that math becomes less relevant the longer the holding period (this is Buffet’s “pay a fair price for a great business” compounder philosophy).

Here’s 3 more bits that show the stock market is still governed by the force of financial gravity (profits):

1) What’s Driving Stock Market Returns (3 min read)
Ben Carlson

It’s ridiculous to assume this means the gains in the stock market are somehow rigged, fake or manipulated.

There is no man behind the curtain pulling levers to ensure stocks go up.

In fact, over the long run, fundamentals still play an important role in the stock market’s success.

There have been times when prices have gotten ahead of themselves but for the most part stock prices have been going up because earnings have been going up.

Another myth of the stock market is that all of the gains are due to multiple expansion. While it is true that valuations have been slowly rising over time as markets have gotten safer [Kris: I’m not sure about “safer” but I expect valuations levitate over time and a priori risk-adjusted returns to get worse], multiple expansion has probably played a smaller role than most people assume.

The late-John Bogle had a simple formula for expected returns in the stock market that looks like this:

Expected Stock Market Returns = Dividend Yield + Earnings Growth +/- the Change in P/E Ratio

In his book Don’t Count on It, Bogle applied his formula to each decade in the stock market going back to the turn of the 20th century to see how well fundamental expectations matched up with the actual returns.

The difference between the two is essentially human emotions.

Bogle published the data through the 2000s so I’ve been updating his work into the 2010s and 2020s. Here’s the latest data through the end of 2023:

There has been some multiple expansion in the 2010s and 2020s but nothing like the 1980s, 1990s or even the 1930s. Earnings growth has been the main driver of stock market returns since the end of the Great Financial Crisis.

2) Why Stocks Move (Twitter thread)
Brett Caughran

Brett is very much in the gears of fundamental pod shop investing providing extensive training to portfolio managers.

Excerpts:

• I’m here to assert: fundamentals are all that matter (with an investment horizon longer than 3 months). Sure, not in a given day, week, month or quarter. Shorter movements in stock prices are certainly influenced by positioning, sentiment & flows.
• But extend the horizon even a few months (let alone a few years) and one thing hasn’t changed in markets over the last two decades, and won’t change in the next two decades: fundamentals are deterministic to stock prices. The analysis I will present below is a ~3 month analysis of why stocks move.
• There are two very common proxies for “fundamentals” when looking at a stock, 1) revisions, i.e. how consensus estimates are changing and 2) consensus expected growth…To try to make this point, I did an analysis of the top & bottom 25 stocks in the S&P 500 this year. I applied a very typical “why did the stock move” decomposition analysis of revisions, P/E and growth algorithm shift to try to isolate why these stocks move. [see the thread for the details].
• By no means am I saying that fundamental equity investing is easy. I’m showing you an ex-post analysis. Monday morning quarterback. The hard part is using process & judgment to identify these dynamics ex-ante. What I’m telling you is fundamentals still matter. Don’t fall into the trap that fundamentals don’t matter. They have this year, and they always will.

Personal bit of color for what it’s worth: a friend of mine is one of the largest and best performing fundamental pod managers on the street. (When I hear what goes into the process I’m convinced the average professional investor looks like a bear on a bicycle compared to what’s happening at the right side of the power law performance curve). I think this friend would very much agree with Brett. Take it as you will.

3) A simple theory of the stock market (7 min read)
Steve Randy Waldman

This post is more of a red pill compared to the others. I’m quite sympathetic to its argument as stock returns maybe have become a load-bearing pillar of the “affluent professionals — call them the top 30%”

Excerpt:

Equity holders who have come to rely upon high equity returns regardless of the timing or valuation of their purchases. Equities fluctuate, sometimes wildly, but the most enfranchised citizens now expect an upward ratchet over a five to ten year horizon. Speculators’ own self-fulfilling behavior joins forces with tacit but determined state support to deliver on that expectation.

While sympathetic, I don’t yet subscribe to Waldman’s deeper suspicion because I haven’t seen the turn card on the flop. Like what happens to the stock market if earnings have a sustained fall without cover for major intervention (like if the last major earnings cliff wasn’t caused by a virus).

Waldman himself includes this chart of corporate profit margins in the post:

A conspiratorial mindset should should be pulled away from the derivative of the function (stock prices) and focused on the function itself — profits margins. Profits varied around 2.5% while the boomers were still hippies, bounced about 5% when I was a kid, found a new home around 10% in the age of smartphones, and then nearly doubled again since covid. The time for profit margins to double roughly halving along the way. There are so many forces that could go into a picture like this plus technicalities of how accounting and tax laws may have changed that I’m not going to embarrass myself with any guesses.

But the output is unmistakable: earnings are growing from both the top* and bottom lines. Again the chart Ben Carlson posted:

When you zoom out, the SPX time series is still tracing what it always has.

*For the top line: see S&P 500 REPORTING YEAR-OVER-YEAR REVENUE GROWTH FOR 13TH STRAIGHT QUARTER