Why The Stock Market Falls (Sometimes)

Whenever the stock market falls people always try to explain why. The honest answer is “no one knows”. We don’t really know why the stock market rises and falls on any given day. There can be any multitude of unknown factors that lead to stock price increases and decreases. Maybe it snowed in NY? Maybe Donald Trump tweeted a lot from the toilet? Maybe a Credit Suisse VIX ETF blew up. Who knows? The needle can move in one direction for lots of reasons.

The one thing we know for certain is that prices move because one side of buyers/sellers is more eager than the other. Again, we don’t really know why that is, but it’s the only factual matter that causes prices to change.

Now, the interesting thing about stocks is that they generate surprisingly stable earnings and dividend yields. Here’s the trailing 10-year growth in earnings and dividends:

In other words, if there is no change in multiples then stocks have pretty consistently earned 4-10% in earnings and dividends. That’s a fairly reliable 7% earnings and dividend yield. So, we can guess that stocks will probably go up more often than not because the underlying entities earn cash flows that mathematically lead to higher prices. If you hold stocks for a long time then the odds of benefiting from that positive earnings and dividend trend is pretty high.

Now, I know some of you hate it when I do this, but I love to think of stocks as super long duration high-quality bonds because it puts the math in simpler terms (at least for me). For instance, a 10-year AAA-rated bond yielding 2% will go down about 10% if interest rates rise by 1%. You’ll still get your 2% per year, but if you’d bought that bond one instant after it fell in price then you’d own the exact same high-quality instrument with a higher yield to maturity than the 2% yielding bond. At the same time, if yields fall by 1% then your 2% yielding bond will rise in price by about 10% and the person who buys that bond one instant after you will earn a lower yield to maturity. In the latter case, you earn about 5 years worth of coupons all in one instant while the buyer at lower yields has to wait 10 years to earn the same 10%.