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Economic
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Economic Letter
FRBSF Economic Letter
96-36; December 13, 1996
Why Do Stock Prices Sometimes Fall in Response to Good Economic News?
On a number of occasions this year, the Labor Department has released
reports showing that employment was growing more rapidly than analysts
had anticipated. For example, the economy added roughly 800,000 jobs in
February and another 239,000 jobs in June. Many people regarded this as
good news, as it was a sign of better prospects for job seekers and of
greater security for those already at work. Yet the Dow Jones Industrial
Average fell by 3 percent in response to the February employment report
and by 2 percent in response to the June report. Some observers were puzzled
by this reaction and wondered why stock prices would fall in response
to news about strong economic growth. This Economic Letter offers
one explanation.
Stock prices are influenced by two countervailing forces. On the one
hand, firms pay dividends to their shareholders, and when there is good
economic news investors may expect these payments to increase. Other things
equal, this would tend to raise stock prices. On the other hand, a promise
to pay $1 sometime in the future isn't worth $1 today. Borrowers generally
have to pay something extra to lenders in order to induce them to part
with their money, and this means that the current price of a promise to
pay $1 sometime in the future is less than $1. In other words, promises
of future payments sell at a discount. Good economic news tends to increase
the rate at which investors discount future payments, so holding expected
dividends constant, it would tend to depress stock prices. The net effect
on stock prices depends on the relative strength of these two forces.
Stock prices rise if the dividend effect is greater, and they fall if
the discount effect dominates.
Why does good economic news tend to increase the rate at which investors
discount future payments? In an efficient capital market, the expected
nominal discount rate is (approximately) equal to the interest rate on
a nominally default-free riskless bond. To see why, suppose that borrowers
were selling claims to a sure $1 payment one period hence. If the yield
on this claim were higher than the rate at which savers discounted the
future, there would be an excess demand for this security, and this would
bid up its price and reduce its yield. Hence market forces tend to equalize
nominal discount rates and risk-free interest rates. Treasury bills are
nominally riskless, and their yields tend to rise in response to strong
economic news. This means that expected nominal discount rates also tend
to rise in response to this news.
The discount effect is illustrated in its purest form by the reaction
of prices on long-term Treasury bonds to news about strong economic growth.
These securities have fixed coupon streams and fixed payments at maturity,
and their prices are determined by discounting these payments back to
the present. Positive news about the economy has no effect on the stream
of payments, because they are predetermined, but it does affect the rate
at which those payments are discounted. In particular, since the Federal
Reserve tries to lean against the wind, it is more likely to raise the
short-term interest rate and less likely to lower it when the economy
is strong. Thus, when investors learn that the economy is stronger than
anticipated, they revise upward their short-term interest rate forecasts,
and long-term bond prices fall because the predetermined flow of payments
is discounted at higher rates.
How are equities different? Among other things, one difference between
equities and bonds is that the flow of dividends is not predetermined.
Firms can increase or decrease dividends in response to changes in earnings,
and that is why some people expect stock prices to respond differently
to strong economic news. For example, the conventional wisdom goes as
follows. Presumably, firms are hiring more workers because they are forecasting
higher demand for their goods and services and want to increase production.
But if that is the case, an increase in employment should be a sign that
earnings are likely to rise. And since stock prices reflect the present
discounted value of future dividend payments, stock prices also should
increase.
This argument implicitly rests on two assumptions: first, that dividends
rise and fall with earnings over the business cycle and, second, that
the market discount factor is either constant or does not vary much over
the business cycle. Neither of these premises is valid. While firms do
tend to increase dividends in response to a permanent increase in earnings,
they usually try to smooth over transitory changes. There is also much
evidence that the market discount factor is highly variable. Taken together,
these two facts suggest that while the conventional wisdom may be appropriate
for permanent changes in earnings, it does not explain the reaction of
stock prices to transitory changes in economic activity. Investors know
that firms probably will not increase dividends by much, if at all, in
response to a transitory increase in earnings. They also know that interest
rates are likely to rise. But then stock prices must fall in order to
reflect the fact that the more or less constant expected dividend stream
is being discounted at higher rates. Thus, stock prices should react to
news about transitory changes in GDP in much the same way as bond prices.
One part of the puzzle concerns the extent to which investors revise
their dividend forecasts in response to news about transitory fluctuations
in output and employment. To investigate this issue, I estimated a simple
forecasting model for dividends and the cyclical component of private
sector GDP. The former are measured by real dividends on the value-weighted
New York Stock Exchange portfolio, and the latter is measured by the ratio
of private sector GDP to consumption. Economic theory suggests that this
ratio is a simple and powerful measure of the cyclical component of GDP
(see Cochrane 1994). According to the Permanent Income Hypothesis, most
households prefer a smooth path of consumption to a variable one, and
they smooth over transitory changes in income by borrowing or lending.
Thus, a change in income that is not accompanied by a change in consumption
is likely to be transitory. For example, when households experience a
temporary decline in income, they borrow to maintain consumption near
their customary levels, and they repay their debts later on when income
returns to higher levels. In this case, we would see a decline in the
income-consumption ratio, and this would correctly signal that households
believe that the change in income is transitory.
According to my simple forecasting model, investors make their forecasts
each quarter based on current and lagged information about dividends and
the income-consumption ratio, and then they wait to see how their forecasts
turn out. Inevitably, some unforeseen events occur and cause actual outcomes
to differ from the predicted values. When the next quarter comes around,
investors learn about these events and observe their forecast errors.
Thus, the errors in the forecasting model represent new information about
dividends and transitory movements in output. Investors learn from this
news and revise their forecasts accordingly. The figure illustrates how
investors would revise their dividend forecasts in response to typical
bits of news about dividends and cyclical movements in output. Here, "typical"
means an average sized forecast error in each of the variables. Evidently,
most of the variation in expected dividends results from news about dividends
themselves. For example, in response to an average sized forecast error
in dividends, investors would revise their dividend forecasts at all horizons
upward by about 5 percent. At constant discount rates, this would also
raise stock prices by around 5 percent. As one would expect, news that
signals a permanent increase in future dividends is likely to raise stock
prices.
In contrast, news about transitory movements in GDP has little influence
on expected dividends. In response to an average sized forecast error
in the income-consumption ratio, expected dividends increase by less than
1 percent, and this response is statistically insignificant. That is,
based on this evidence, we cannot rule out the possibility that news about
transitory movements in output has no influence on expected dividends.
Why does news about transitory fluctuations in output have so little
influence on dividend forecasts? After all, one would think that the earnings
of most firms would rise when private sector GDP increases and fall when
private sector GDP decreases. But earnings and dividends are not the same,
and there is a great deal of evidence going back to Lintner (1956) that
firms prefer to smooth their dividend payments over the business cycle.
One explanation for dividend smoothing is based on the fact that managers
know more about a firm's prospects than market participants. A change
in dividends would communicate this inside information to the market and
would have a big effect on a firm's equity price. Managers are reluctant
to change dividends because this signaling channel would contribute to
the volatility of the firm's stock price. Of course, when there is a permanent
change in a firm's prospects, managers must alter their dividend policy.
This is evident in the figure, which shows that news about dividends tends
to have a permanent effect on expected dividends. But managers can
smooth dividends over the business cycle. If they decline to raise dividends
during expansions, they can avoid cutting them in recessions. The retained
earnings that accumulate during the upswing are paid out as dividends
during the downswing.
Since news about transitory movements in output has little effect on
expected dividends, it must be the case that the reaction of stock prices
is mostly due to changes in the market discount factor. This variable
is unobserved, so I cannot bring direct evidence to bear on this question.
However, two bits of indirect evidence support my interpretation.
First, as mentioned above, the expected discount rate is approximately
equal to the yield on a Treasury bill and tends to rise in response to
news of a cyclical expansion. Since expected dividends are roughly constant
and expected discount rates are increasing, it follows that stock prices
must fall.
There is also some evidence that the market discount factor is enormously
volatile. Again, although this variable is unobserved, one can use security
market data to estimate a lower bound on its variance (see Hansen and
Jagannathan 1991). For example, when I apply a version of their method
to returns on 3-month Treasury bills and the value-weighted New York Stock
Exchange portfolio, I find that the quarterly standard deviation of the
nominal discount factor must be at least 9.4 percent. To put this in perspective,
the standard error of quarterly returns on the NYSE portfolio is 4.4 percent.
Evidently the discount factor is more than twice as variable as stock
returns themselves! A model that implicitly assumes that it is constant
is not likely to describe the market very well.
According to conventional wisdom, stock prices should rise in response
to news of strong economic growth, yet we observe that stock prices sometimes
fall. The conventional wisdom is likely to be correct when the news concerns
a permanent change in activity but not when it concerns a transitory change.
Firms smooth dividend payments over the business cycle, and investors
price these smooth dividend streams using variable discount factors. This
results in a fall in stock prices when the market learns of a transitory
increase in economic activity.
Timothy Cogley
Senior Economist
Cochrane, John H. 1994. "Permanent and Transitory Components of
GNP and Stock Prices." Quarterly Journal of Economics 109,
pp. 241-266.
Hansen, Lars Peter, and Ravi Jagannathan. 1991. "Implications of
Security Market Data for Models of Dynamic Economies." Journal
of Political Economy 99, pp. 225-262.
Lintner, John. 1956. "The Distribution of Incomes of Corporations
among Dividends, Retained Earnings and Taxes." American Economic
Review 46, pp. 97-113.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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