Chapter 3 The Day-To-Day Drivers Of Stock Market Returns

Summary:

(1) Earning growth is the primary driver of day-to-day stock market returns. Companies that generate high earning growth outperform, while companies that record low levels of growth underperform. Sales growth is a secondary factor.

(2) Earning growth is not predictive of future stock market returns. That is, the market is very efficient in pricing in changes in earnings growth as they are reported.

(3) Free cash flow growth is also a significant factor in driving stock market returns. Free cash flow growth is not nearly as strong a factor as earnings growth, but it appears to be somewhat independent from earnings in driving returns.

(4) Unlike earning growth, free cash growth is predictive. That is, the market appears less efficient in discounting changes in free cash flow growth than it is in discounting earnings growth. (Therefore, free cash flow growth is the first basic that could be used to form a forward-looking quantitative test)

(5) The stock market isn't driven wholly by fundamentals, however. The thoughts, hopes, beliefs, and fears of inverstors---what we call investor sentiment---also drive market returns. The interaction between fundamentals and investor sentiment determines a stock's price.

(6) Wall Street analysts' earning estimates reflect investor expectations. Positive earnings surprises(earning reports that beat average analyst estimates) cause stocks to outperform, on a day-to-day basis, while negative earnings surprises(earning that come in below estimates) cause stocks to underperform.

(7) In terms of predictive power, however, our research shows that earnings surprises were predictive of excess returns in the past but seem to have lost that predictive power in recent years.

(8) A stock's valuation, in terms of its P / E ratio, reflects investor sentiment and is a strong factor in driving day-to-day stock market returns. Low valuation stocks of companies that perform better than expected, in terms of earnings growth, outperform significantly, and high valuation stocks of companies that perform worse that expected underperform significantly.

(9) While earning growth is the strongest fundamental driver of returns, valuation (as measured here by the price-to-forward earnings estimate ration) is the strongest investor sentiment-related driver of returns.