The Fuel in Stock Prices’ Engines

The Financial World According to Inya” Column
by Inya Ivkovic, MA

Ah, an odd thing those stock prices…and here is the story of two stocks that may at least help explain what fuels stock prices’ engines. Back in July of last year, it was time to report Q2 results. Mostly, the results were dismal, including Morgan Stanley’s, which were negative earnings per share for the fourth consecutive quarter and revenues cut in half year-over-year. On the same day that Morgan Stanley posted its dreadful Q2/2009 results, so did Apple — post quarterly results, I mean, only a completely different picture had emerged. In stark contrast to Morgan Stanley’s performance, Apple posted 60% higher earnings on 30% higher revenues.

Mainly due to such a strong second quarter, Apple’s stock went on to gain roughly 31%, or about double what the broader market had earned. And Morgan Stanley’s stock? Surprise, surprise! Despite earnings losses and reduced revenues, it also went on to gain about 30%.

“How is that possible?” you may ask. The answer is simple — earnings and revenues are not the only factors that fuel stock market gains. In fact, factors impacting stock prices are manifold, which is the main reason why the movements of a particular stock, or the market as a whole, are so difficult to predict in the short term.

If stock market prices are difficult to predict in the short term, that seems very understandable. But what about making the same predictions in the long term? Is it possible to identify and quantify factors driving stock prices for the long haul?

Academic research shows that in the past 35 years and over several broad and different types of markets, stock market returns were driven by a number of factors, the major ones being inflation, real business and asset growth rates or real book value growth, price-to-book growth, and dividend income. More precisely, in the past 35 years, it seems that approximately two-thirds of stock market returns resulted directly from inflation and dividend income, both of which are something that investors rarely pay attention to because both are seriously lacking in the “sexiness” department.

But some very smart people couldn’t care less about the sexiness factor. Just ask Warren Buffett, who said it once, “If inflation comes, stocks are the best bet.” Some analysts and macroeconomists call inflation a “virus” that has permanently infiltrated the stock market after the World War II ended and that is now virtually incurable. In the long term, inflation destroys returns of fixed-income securities. In contrast, stocks have the ability to affect their earnings flows when companies earn more in the rising price environment. In a perverse sort of way, you could say the inflation virus has infiltrated the companies’ bottom lines and, by proxy, stock market prices, too.

As far as dividend income is concerned, ignoring dividend yield is unwise in any investment environment. Those who do, do so at their own peril. Even at times when stock prices are appreciating, dividend income provides a nice cushion for those difficult times that inevitably cycle their way around.

Considering the massive economic stimulus programs that have been pumped into the global financial systems, stock market investors should pay double the attention to factors such as inflation and dividend yield. If there is anything certain these days, it would be that a period of high inflation is on its way. Additionally, considering the stock market’s rallies from the lows hit in March of last year, dividend yields are harder and harder to find. But there are dividend yield gems that come from industries that usually cope well in a rising price environment, such as food and utility stocks.