Why Does the Stock Market Fluctuate While the Economy Stays Steady?

Oct. 04, 2024

Stock market volatility often dominates headlines, with dramatic rises and falls that seem disconnected from the broader economy. But is it really? During his visit to Stockholm, UCLA’s Andrew Atkeson explains how small shifts in investor expectations about the distribution of corporate income can cause significant market swings—without destabilizing the economy.

Your research suggest that stock prices are not as volatile as they might seem. Can you explain why stock prices move up and down so much, but the economy itself doesn’t appear to change as wildly? 

We are interested in explaining why the stock market valuation of corporations in the United States has been so volatile over the course of the last century while the macroeconomy in general and the investment behavior of U.S. corporations in particular has been relatively stable. In both papers, we focus on the idea that relatively small fluctuations in investors’ expectations of how overall income in the corporate sector will be split between firm owners and workers in the long run that drives the volatility of their stock market value without substantially impacting near term macroeconomic fluctuations.

Could you explain how even small changes in these expectations can cause significant market movements? 

This question gets to the heart of where our analysis differs from most of the prior literature. The standard assumption in prior models of stock market volatility is that movements in investors’ expectations of cash flows in the distant future do not have a large impact on the value of the stock market. This is because these prior models assume that investors “discount” that news at a rate consistent with the high average return investors have earned in the stock market. We depart from this assumption of high discount rates for cash flow news, and it is on this point that the debate between our view and the standard view in finance will play out going forward.

For someone who isn’t a finance expert, why should they care whether stock prices are volatile because of cash flows or something else? What difference does it make to the average investor or a person saving for retirement? 

Perhaps the most important message of our research is that the volatility of the stock market is neither a result of irrational forces nor a result of investors’ expectations of future economic growth. Instead, our message is that booms and busts in the stock market are more a reflection of investors’ expectations of the fraction of corporate income that will flow to firm owners versus workers in the long run. If we might quote Hanno Lustig, Stijn Van Nieuwerburgh, and Bruce Springsteen, our view is that “Good times on Wall Street are bad times on Main Street”.

How should policymakers and regulators interpret your findings? Should they worry less about bubbles in stock prices and focus more on the real economy? 

Our paper is part of a broader literature that suggests that macroeconomic policymakers in general and central bankers in particular should not put so much weight on booms and busts in the stock market in deciding macroeconomic policy. These policymakers should focus on overall macroeconomic performance. One exception to this rule is for policymakers interested in economic inequality. Our view is that stock market booms and busts do reflect changing expectations of future inequality in the division of corporate incomes.

What can your research tell us about future market behavior, especially in times of economic uncertainty, like during the pandemic or periods of high inflation? 

One of the great puzzles of the U.S. stock market over the past 20 years or so is that the value of the market has been so high relative to typical valuation benchmarks such as GDP or corporate earnings. Standard financial theory has offered the prediction that these high valuations would lead to low future stock returns. But instead, the U.S. stock market has boomed over this time period. Our research suggests that the high valuation of the stock market over the past 20 years has, in fact, been justified by high cash flows to firm owners and rapid growth of dividends per share and thus investors saving for retirement might not worry so much about future stock returns.