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Trillium News

May 1, 2001

Market Watch (Archive)

Were I to pick a song to serve as the soundtrack for the past two years in the stock market, it would be Jimi Hendrix’s “Manic Depression.” From euphoric highs to dismal lows, investors have been on a ride that has grown demonstrably wilder over the past few years. In polite circles it’s called “increased volatility.” And while none of us much like it, we probably favor three of the key factors that have brought it about.

Information technology is the most obvious culprit. Where company or economic news used to take days or weeks to fully penetrate investors’ thinking, today the Internet has telescoped the process into hours if not minutes. Just as important, the Securities and Exchange Commission issued Regulation FD (“Fair Disclosure”) last fall, prohibiting companies from disclosing information on a selective basis. If a CEO tells Warren Buffett something, she has to tell you at the same time. This further democratizes the delivery of news and telescopes its impact on stock prices.

The third, somewhat surprising reason for increased volatility is the low-inflation environment we have otherwise come to embrace. Stock prices are set by investors deciding what they will pay today for an expected future stream of corporate earnings and dividends. The larger the future benefit, the more you’ll pay for it today. And the further into the future you can reliably predict that benefit, the larger the total benefit is likely to be.

When inflation is low, prices are stable. And when prices are stable you can predict the future earnings of a company more reliably because you can confidently estimate the company’s key costs-labor, raw materials, etc. Investors are confident they can look far into the future when assessing the total benefit they’re paying for. This is the major reason stock prices rose over the past decade: as inflation fell steadily the visibility of future earnings increased, allowing investors to price a longer-and thus larger-benefit into stock prices.

So what does this have to do with volatility? If investors are looking far into the future when pricing stocks, changes in their outlook for a company-whether positive or negative-will be magnified by the long view they’re taking.

Say I expect 10% annual earnings growth for the next two years from a company. If I change my annual growth estimate by 1% – downward, say – then my expected total earnings growth drops from 21% to 19%. Not a big deal. But what if I was expecting earnings to grow 10% per year for the next 10 years? Then a 1% cut in my annual growth estimate pulls total expected earnings growth down from 159% to 137%. That’s a big difference and one that will show up in the price you’re willing to pay.

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