Elevated Volatility's Permanent Impact on Stock Market Valuations

Includes: DIA, SPY
by: Dr. Hugh Akston

Surely the stock market collapse of 2008 should present amazing buying opportunities for those fortunate enough to have hidden a pile of cash under a mattress at the beginning of the year…right? Certainly this bear market has caused tremendous wealth destruction, and based on the most recent market low it has been the second worst bear market on record. However, before investors plow back into this market, they should consider why the market has declined and how much further the market could still fall. If we do see a bear market similar to that of 1930 – 1932 we could still see another -50% decline from here.

So why the market-wide sell-off, and why shouldn’t investors bet on the market snapping back? Let’s look at this on the individual stock level. The price or value of a stock represents the value of a perpetual stream of cash flows discounted at an appropriate risk adjusted rate. According to the Capital Asset Pricing Model (CAPM) the appropriate risk adjusted rate is the weighted average cost of capital (WACC) for the company. The WACC is the cost a company pays for its capital. This rate takes into account the business risk of the company and the financing risk of the respective capital structure. A company’s WACC is comprised of the company’s cost of borrowing (cost of debt), the market risk premium, and the company specific level of risk relative to the overall market (measured as beta). The market risk premium represents the amount of return that investors require to invest in stocks (risky assets) as opposed to government bonds (risk-free assets).

Volatility can be viewed as a measure of uncertainty. I compiled some historical data for the S&P 500 since 1990 to see how this current volatility compares historically. I calculated the percent change between the day high and day low to measure intraday volatility and then mapped the S&P 500 over it. As you can see below we are living in unprecedented times regarding the level of volatility/uncertainty in the market.

Taking an even longer view going back to 1961 you can see that this level of intraday volatility is unprecedented except for the 1987 crash.

If we follow this line of reasoning through, an elevated level of uncertainty should lead to a higher market risk premium which as a reminder is the amount of return that investors require to invest in stocks (risky assets) as opposed to government bonds (risk-free assets). The market risk premium is an input into the WACC calculation which is used by the market to discount the value of the expected cash flows of the stock. If we assume that a stock is worth the discounted rate of free cash flows in perpetuity, a simple formula using EPS for valuing a stock is as follows:

Stock price = Earnings per share/ (WACC – growth rate)

The below example shows the drop in the value of a hypothetical stock due to an increase in the market risk premium alone. As you can see below, an increase in the market risk premium from 6% to 8% leads to a drop in the value of the stock of roughly -25% even though the earnings power (earnings per share) of the company remains constant.

The example shows that an increase in the risk premium for investing in risky assets would result in a significant decline in the stock value even without any deterioration in the fundamental profitability of the company. It is important to note that the market risk premium is the same “rate” for all stocks so any change would impact the entire asset class or the stock market as a whole. I think the unprecedented level of volatility suggests that part of the market sell-off is due to a permanent revaluation of risk. Admittedly, with so many variables and moving parts that go into valuing a stock, it is virtually impossible to know what is baked into current prices, regardless a higher discount rate will lead to a lower value for stocks. Investors should not expect to recover this “value” because elevated volatility in the financial markets has likely led to a permanent impairment of stock valuations.

Disclosure: None.