While it’s difficult to find evidence of a direct relationship between economic growth and equity returns, it is possible to explain how news stories – such as those about economic growth – affect market sentiment.
The importance of sentiment
Market sentiment is the biggest driver of investment returns in the short-to-medium term. As investors, we usually purchase assets that pay future cash flows. In theory, the price that we pay for these assets should be the discounted value of their future income streams. For example, in the case of shares, the future cash flows are earnings and dividends; which in most cases don’t vary as much from year to year as share prices do.
If future cash flows don’t vary that much from year to year, then why are asset prices so volatile?
Using shares again as an example, the value of a share is often expressed using a price-earnings multiple or P/E ratio, which represents how much investors are willing to pay for a share’s future earnings. This multiple rises and falls depending on investors’ expectations of the future.
If investors are optimistic, they buy the share, increasing its price. If they are pessimistic, they sell the share and its price falls. In other words, the price paid for the future earnings depends on investors’ confidence – or lack thereof. Over the longer term, prices usually trend towards fundamentals, but in the short-to- medium term, market sentiment rules.
The idea that markets are driven by confidence is not a new one. John Maynard Keynes observed that faced with uncertainty, the decisions investors make about the future “can only be made as a result of animal spirits” and that such decisions are not “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities”.
History shows that investors have a bipolar relationship with uncertainty about the future. Sometimes they are energised by it, at others they are paralysed. How can we explain such changes in investor confidence?
Everyone loves a good story
One of the best ways to share important information is to use a story. A good story doesn’t just convey facts and ideas; it also transmits emotion and can motivate people to act. Investors are not immune to the power of a good story, as economist Robert Shiller explains in his book, Irrational Exuberance:
Those who sell stocks to the general public often tend to tell a story about the stock, a vivid story describing the history of the company, the nature of the product and how the public is using the product. The sales call does not as often engage in discussions of quantity or probability, or of whether the price is at right levels in terms of quantitative evidence about future dividends or earnings. These quantitative factors are not as congenial to the narrative-based decision-making that comes naturally to people.