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ETF Specialist

Is Market Volatility Justified?

The stock market has historically been more volatile than corporate earnings, but uncertainty can justify that volatility.

At the 2018 Morningstar Investment Conference, David Herro of Oakmark argued that investors often overreact to macroeconomic news, not properly evaluating their impact on a company’s future cash flows, which can create opportunities for value investors like him. Nobel Laureate Robert Shiller made a similar argument that market prices are more volatile than they should be, based on changes in future dividends [1]. That perspective is intuitive. But is it true? While the market probably doesn't always get prices right, a more careful look at historical earnings suggests that the volatility in stock prices is justified on average.

In Theory
A stock's intrinsic value is the present value of its future cash flows plus its current cash balance minus debt. These cash flows are risky because they represent the cash that is left over at each firm after all the bills are paid, including interest payments to bondholders, who get paid before equity investors. Given the large impact of cash flows on fundamental value, it might seem like stock prices should be roughly as volatile as their firms’ cash flows. But investors don’t know what those cash flows will be ahead of time and that uncertainty is a source of added volatility.