What moves the stock market?

• Author: Campbell, John Y.
• Position: Research Summaries

Stock prices tend to move with the state of the economy. This fact is both familiar--it describes the United States, the United Kingdom, and many other national markets in the postwar period, the interwar period, and the 19th Century(1)--and surprisingly hard to explain. My most recent work, with John H. Cochrane, proposes a simple model that accounts for this and other aspects of aggregate stock market behavior.

Financial theorists describe asset prices as expected present values of future payments, discounted to adjust for time and risk. This can be seen as a matter of accounting: if an asset's price is high today, then either its price must be even higher tomorrow, or its dividend must be high tomorrow, or its rate of return between today and tomorrow (the ratio of price plus dividend tomorrow to price today) must be low. If prices cannot grow explosively forever, then an asset with a high price today must have some combination of high dividends and low returns over the indefinite future. Furthermore, investors must recognize this fact in forming their expectations, so when an asset price is high, investors must expect some combination of high future dividends and low future returns.

In a series of papers, some written jointly with Robert J. Shiller, I have developed this simple insight into a quantitative framework for analyzing the variation of asset prices. As a matter of accounting, price movements must be driven by some combination of changing expectations ("news") about future dividends and changing expectations about future returns; the latter in turn can be broken into news about future riskless real interest rates and news about future excess returns on risky assets over riskless ones.(2)

Until the early 1980s, most financial economists believed that there was very little predictable variation in stock returns and that dividend news was by far the most important factor driving stock market fluctuations. The first challenge to this orthodoxy came from Stephen F. LeRoy and Richard Porter, and from Shiller.(3) These authors pointed out that dividends, and plausible measures of expectations about future dividends, are far less volatile than stock prices. A few years later, Eugene F. Fama and Kenneth R. French studied the predictability of stock returns from past returns and dividend-price ratios. They pointed out that the predictable variation in stock returns becomes increasingly impressive--in the sense that it accounts for an...