Intro: Equity market moves in the short term tend to reflect changes in economic or corporate fundamentals relative to consensus expectations, causing adjustments in prices to reflect the likelihood of higher or lower earnings and dividends in the future. The longer the time horizon, the more important actual earnings and dividends become. Over the very long term, valuation changes tend to net out, leaving the initial dividend yield and dividend growth as the main market drivers.
Short Term: It’s All Relative
There is very little correlation between earnings/dividends and equity prices over any given market cycle, as equity markets price in expected earnings and dividends, and so it is changes in earnings and dividends relative to expectations that tend to drive equity markets. If earnings and dividends come in higher than expected, equity prices will tend to rise, as will equity valuations as prices rise faster than earnings and dividends themselves.
Taking a simple example, if an economy is expected to grow at 5% per year but performs weaker than expected and grows at say 4%, the equity market may experience a negative reaction to the underperformance relative to expectations in the short term.
Long Term: Valuations are the Main Driver
Prevailing equity valuations have very little impact on equity market moves in the near term, but an incredibly strong impact over the longer term. It is the very fact that valuations don’t tend to matter in the short term that allows herd behavior to result in the kind of extreme valuations we see in the US today. At major market tops investors tend to be highly optimistic despite the outlook being the weakest, and the realization that returns are unlikely to be as high as expected gives way to selling pressure, triggering the market decline.
Valuations have a strong tendency to mean revert over time as the pendulum of optimism and pessimism swings from one extreme to another. Because of this, over the long term, equity markets returns are highly predictable; when valuations are high, future returns tend to be poor. The best valuation metrics have ~90% correlation with subsequent market returns. One such measure is the cyclically-adjusted dividend yield as shown below:
Of course, fundamentals are also important, as the higher nominal GDP growth, the higher dividend growth is likely to be. However, high nominal GDP tends to result in high interest rates, which offsets the positive impact on returns by reducing valuation multiples (high interest rates make discounted dividends on stocks less attractive). As a result, the bulk of equity performance over a long term tends to be driven by valuation changes.
This can be seen in the following chart which shows the 10-year rolling returns of US stocks broken down into returns from the dividend yield, dividend growth, and valuation changes. As you can see, changes in valuations tend to be the most important driver of bull and bear markets as they are much more volatile.
Very Long Term: All About Dividend Yield and Growth
Over the very long term, valuation changes tend to net out leaving the dividend yield and dividend growth as the main sources of equity returns. Taking the example of the US, over the past 70 years the S&P500 has returned an annualised 11%, give or take. This has come from an average dividend yield of 3.4%, dividend growth of 6.3%, and a 1.3% annual contribution from valuation changes reflecting the decline in the dividend yield over this period.
Even as valuations have risen significantly over the past 70 years, this has had a very little positive contribution to total returns, with dividend growth and the dividend yield providing the lions share. For this reason, forecasting equity returns over the long term is fairly straightforward as it largely boils down to the rate of nominal GDP growth and the dividend yield.
Major Market Moves are Driven by Combinations of Factors
Major market crashes are caused by combinations of negative factors such as expensive valuations, high levels of optimism surrounding the economy and the market, and, crucially, a deterioration in the trend. Conversely, major market rallies tend to result from cheap valuations, widespread pessimism, and oversold momentum.
Market crashes can still occur in the absence of extreme valuations as was the case in 1987. Huge rallies can also occur from already-high valuations, even when sentiment is already highly bullish, if the trend remains strong. However, generally speaking, combinations of positive or negative factors give a much stronger potential for large gains or losses.
