1. Market Fundamentals
The market fundamental (or fundamental value) of an asset is the
discounted present value of the stream of future cash flows attached to
the asset.
2. • When asset prices are determined by market fundamentals, the value of
the asset depends positively on future expected cash flows and negatively
on the discount rate used to obtain the present value. Although some
estimates of market fundamentals move together with market values, they
tend to exhibit lower volatility. This evidence, especially in the case of the
stock market, suggests that asset prices deviate from their fundamental
values.
• The cash flows obtained by the owner of a stock are the dividends
distributed by the firm. Since the source of dividends is the earnings
generated by the firm, investors must take into account the factors behind
earnings when forming expectations concerning future dividends. The most
important factors that determine the evolution of expected earnings are
the future profitability of current operations and future investment
projects.
3. • The second component of the market fundamental of stocks is the discount
rate used to obtain the present value of dividends. Given a fixed stream of
cash flows, an increase in expected future returns implies that the market
fundamental decreases because the discount rate is higher. Expected
returns for individual stocks and for the stock market as a whole are not
constant, and different financial and macroeconomic variables contain
significant information to forecast returns. This evidence implies that
changes in expectations of future returns (i.e., changes in discount rates)
can produce fluctuations in market fundamentals. In fact, John
Campbell (1991) shows that movements in the aggregate stock market
prices are mainly driven by news about future expected returns. However,
Tuomo Vuolteenaho (2002) shows that stock returns for individual firms
are mainly driven by cash-flow news, and that cash-flow news is largely
idiosyncratic, while expected-returns news is common across firms.
4. • By a diversification argument, the results of both authors are compatible.
Historically, the average real return on the stock market is higher than the
real return on treasury bonds. The difference between both returns is
denominated as excess return. It is a reward for holding a risky security.
Hence, we can decompose the fluctuations in expected returns into
changes in the expected return on a treasury bond and the expected excess
return. John Campbell and John Ammer (1993) show that stock returns
movement can be attributed to news about future excess returns, and that
news about the return on a treasury bond has little impact. Therefore the
most important component in the discount rate is the excess return. Since
it is a reward for risk, the factors that determine its magnitude are
investors’ attitudes toward risk and the risk associated with the stock
market. The variables that forecast excess returns are connected to
macroeconomic activity. Returns forecasts are high at the bottom of
business cycles and low at peaks.
5. • Different valuation ratios have been proposed to anticipate the evolution of stock
prices. The most common is the price-earnings ratio, which is computed as the
quotient between the price of a stock and its earnings per share. Given the
definition of market fundamental, the price-earnings ratio depends positively on
future expected earnings growth and negatively on future expected returns. This
ratio presents long cycles of approximately thirty years (for the U.S. aggregate
stock market during the last century) together with shorter fluctuations. For the
aggregate stock market, some authors argue that the price-earnings ratio
incorporates significant information to predict future returns for long horizons
(more than five years). This conclusion has been criticized mostly from a
statistical point of view. John Cochrane (1992) argues in favor of the capacity of
the price-dividend ratio to predict returns. The author shows that as the ratio is
not constant, it must predict changes in dividend growth or changes in returns.
He also provides evidence showing that almost all variation in the ratio is due to
changes in returns forecasts.
6. • The market fundamental of a house can be analyzed through similar
arguments. It is the expected present value of future housing
services. Because the value of housing services is not observable,
some authors approximate this magnitude by the rental value of the
house. This variable depends on a wide set of factors, such as the
characteristics of the rental market or the evolution of the
population. Different empirical studies emphasize the importance of
the fluctuations in the discount rate in determining housing prices.
Further, housing provides collateral services and allows for tax
deductions. Intangible services and tax variables may also influence
the value of the stock.
7. • There are also other assets where the market fundamental may be hard to
define. For instance, the exchange rate is the price of two currencies, and
hence the relative price of two assets. Exchange rates may be influenced by
the availability of international reserves, balance-of-payments deficits, and
monetary and fiscal policies. These macroeconomic aggregates are usually
referred to as market fundamentals. Economists build stylized models to
evaluate the effects of these market fundamentals.
• SEE ALSO Bubbles; Business Cycles, Real; Discounted Present Value;
Financial Markets; Market Correction; Ponzi Scheme; Rate of Profit; Risk-
Return Tradeoff; Speculation; Stock Exchanges
• BIBLIOGRAPHY
• Campbell, John Y. 1991. A Variance Decomposition for Stock
Returns. Economic Journal 101: 157–179.
