Is market volatility justified?

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

Alex Bryan 21 August, 2018 | 5:00PM

Nobel Laureate Robert Shiller once argued that market prices are more volatile than they should be, based on changes in future dividends. 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.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.