Saturday, October 26, 2024

The drivers of stock prices are time varying

 


Who would have thought that the drivers of stock prices are time-varying? This simple idea makes perfect sense and is presented in the paper "Time-varying Drivers of Stock Prices"

The author finds that cash flow expectations are more important during period of financial stress and uncertainty. You worry about the earnings to be discounted during those periods. 

On the other hand, you will focus on the discount rate during periods of expansion. It is likely earnings will be trending, and the focus will be on when you get the cash flows. 

Inflation will be an important driver when inflation is high and less important during periods of low inflation. 

Factor returns will not track with earnings growth when there is low financial uncertainty, but track with earnings when uncertainty is high.

This a good reason to be macro focused. At times, the stock market will be cash flow focused and at other periods it will be discount, but the problem is that macro focus will change with the environment. These time-varying drivers will be very sensitive to the sector studied which also makes sense. Some sectors will be more sensitive to cash flows during swings in the business cycle. It is critical to focus on the right drivers at the right time.

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