It’s easy to see how the stock market might fall by a fifth when it is learned (or market participants think they have learned -- see my earlier blog post) that a one year recession will occur that would not have occurred otherwise. Suppose that, absent a recession, corporate earnings grow perpetually at rate g. A recession means that earnings drop by 15% for one year, after which they resume their previous growth rate g. A 10-15% drop in earnings is typical of postwar recessions. Relative to the counterfactual, the 15% drop lasts forever, so this by itself reduces equity values by 15%. In addition, growth does not occur for twelve months, which reduces earnings in all years after the recession by exp(-g). So values are hurt by almost 15% + g, which is somewhere between 15 and 20 percent. If the recession lasted 2 years instead of one, values would be hurt by less than 15% + 2g, which is still not much beyond 20%.
In fact, the U.S. stock market has fallen by about third. Even the nonfinancial components of the stock market have fallen 30%. This seems hard to explain merely with bad news about earnings. Rather, it likely reflects a change in the valuation of a given earnings stream. In other words, you can buy the same earnings stream cheaper now than you could last year. I am not the first one to suggest that time-varying discount factors (as opposed to news about “fundamentals” or earnings streams) are an important reason for stock market fluctuations – see the last couple of decades of asset pricing research.
Tuesday, October 7, 2008
The Relative Importance of Dividend News and Discount Factors in the 2008 Stock Market
Here is my back-of-the-envelope version. Let me know if you have a more precise decomposition.