Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 24

A fixed interest guy’s take on share market volatility

What caused the share market's sharp pull-back during June 2013? Much of the analysis struggled for an explanation, but to me it seemed fairly obvious.

Typical commentaries about fluctuations in stock indices focus on earnings. When the market rises, it’s attributed to something like a positive reporting season for earnings, or some other event that means expectations for the earnings outlook are optimistic. When the market falls, there’s pessimism about earnings downgrades.

However, when the global share markets went into a tail spin from late May to late June, the standard commentary was more like:  “How can this be? The US economy is improving and earnings growth is positive. Something is wrong.” From professional equity fund managers and stock brokers to commentators in the popular press, the refrain was similar.

The trigger for the negative sentiment in world stock markets was Federal Reserve Chairman, Ben Bernanke’s comments that the time may be approaching for the Fed to start reducing its purchases of US Treasury bonds. The economy was doing better and seemed to be getting onto a more solid footing, so the need for monetary policy to provide support could be becoming less than it has been.

The majority of equity commentators focussed on the positive outlook behind Bernanke’s remarks. Surely the Fed Chairman was telling everyone to buy equities because the economy would support earnings growth!  Why didn’t everyone jump on board?

Share prices are not just about future earnings

Those commentators miss something important about share prices. While it is true that they are based on company earnings – and vitally so - they aren’t merely about earnings. They are also about the rate of return that those earnings are priced to deliver to the investor.

In technical terms, share prices are the discounted net present value of the expected future stream of earnings. Discount rates are largely determined in the bond market, and the Fed Chairman’s comments had a significant impact on bond yields and therefore on the stock market discount rate.

As a fixed interest analyst and manager, I’ve lived with this reality for decades. It’s the only thing at play in fixed interest, where earnings don’t change.  When yields go up, the value of a fixed nominal cash flow goes down.

The same principle is at work in the way markets determine share prices. It’s not as obvious because of the fact that the earnings outlook is constantly being reassessed as well, but it’s there all the time. Let me explain.

If someone offers you an investment that will pay you $100 in year one and grow by 1% a year forever, how much would you pay for it? The answer depends on the rate of return you want it to give you.

Let’s assume the asset is priced to return 5%. You’d pay $95.24 for the first year’s payment, because you’d earn $4.76, which is exactly 5% of $95.24. In year 2 you will be paid $101, for which you would pay $91.61 to represent 5% per annum over the two years. Making the same calculation – compounded of course – for each other year generates a series of amounts that add up to $2,500.

Now let’s suppose that the earnings outlook improves and the promise is a payment of $100 that will grow by 1.5% a year.  If still priced to return 5% then every payment is worth more and the total asset value would rise by 14% to $2,857.  For example, the year 2 payment of $101.50 when discounted is worth $92.06.

But what if the assumed rate of return – the discount rate - is also now higher? How does the outcome change? If, say, the discount rate goes up to 6.0%, then the year 2 payment of $101.50 is now only worth $90.33. Repeat the calculation for every year into the future and the total value of the asset comes to $2,222. This is 11% below the original $2,500 price despite the stronger earnings growth.

Equities are long duration assets

These are all large percentage changes because, in effect, equities are long duration assets. That is, the average time over which investors receive their cash flows is very long. This means that share prices are highly sensitive to changes in the assumptions about both earnings growth and the discount rate that is used to value the earnings outlook.

So, what I think happened to shares during June was this. The earnings outlook was positive, but that was already priced into the market after the strong run up in prices that had taken place in the first few months of 2013. (That rally saw the US and Australian markets up about 18%, implying about a 1% per annum average improvement in earnings growth had been priced in.) The bond market’s reaction to Bernanke’s remarks was that less buying by the Fed would mean higher bond yields. With the long bond rate as the key input to the discount rate, the equity market reacted exactly as a long duration asset should when there is a rise in its discount rate. The expected stream of earnings was now required to deliver a higher rate of return and thus the price for those earnings had to be reduced.

The duration of the stock market is in most cases a similar figure to the price-earnings ratio. That is, currently around 17 years. So, working backwards, I infer from a 10% fall in the Australian share indices that the discount rate was increased as a result of Ben Bernanke’s policy signal by just over 0.5%.  This lines up pretty well with the fact that the ten year bond rate in Australia rose from 3.2% to 3.8% over the late May to late June period.

I’m not suggesting that this was a conscious move by market participants, overtly thinking that the discount rate has gone up 0.6% so share prices have to be cut by 10% (0.6% x 17). But implicitly this is the dynamic at work as all the actions of all the buyers and sellers combine to determine the prices at which shares trade.

Therefore, the falling market in shares that followed Bernanke’s statement was not, to me, the surprising, inexplicable thing that it seemed to be to so many commentators. It was logical, with the world’s bond markets and stock markets moving in lock step with one another as investors and traders tried to understand the significance of what Bernanke was saying.

That doesn’t mean that whenever bond yields go up, share prices always go down. If yields rise because there is another improvement in the economic and earnings outlook, then the rise in earnings growth expectations may well dominate the share markets. A 1% rise in earnings growth expectations combined with a 0.5% rise in the discount rate would still produce a positive valuation impact on share prices of about +8%.

These simple maths also help explain why the share market is so volatile. It’s not that it’s an irrational, casino-like beast that bucks and dives for no good reason. No, it’s just a long duration market reacting to changes in earnings growth and discount rate assumptions.

Thinking about markets like this doesn’t produce as many startling headlines for the press. But it does help you understand why your financial planner probably keeps trying to tell you not to worry about periods as short as a month. Shares are long term assets that should be looked at only over the long term. In the same way bonds are medium term assets that should be looked at over the medium term, not weeks or months. If your time horizon is a month, then the asset that aligns with your time horizon is cash.

 

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management, and is now an External Member of the GESB Board Investment Committee and a consultant and writer on fixed interest, including for KangaNews.

 


 

Leave a Comment:

RELATED ARTICLES

A world out of sync with inflation

Fighting the last war

Lessons from a century of virus plagues

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.