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Stock Market Basics – The 3 Pillars

Stock Market Basics – The 3 Pillars

Author: Chris Steward, CFP®, CFA®, RICP®, M.A. (CANTAB) | Director of Investments at Impact Advisors Group

It is worth revisiting some of the basics about the stock market, and debunk some common myths. It is often said that there are 3 Pillars that support stock prices: Earnings, Interest Rates and Valuation. The stock market is said to be a voting mechanism in the short run as some popular stocks get bid up and others lag; but a weighing mechanism in the long run. What the market weighs, is earnings. Those companies that can generate consistently high earnings will outperform other stocks regardless of whether or not they pay a dividend (more on this later).

Interest rates are important as an alternative to equity investments. As bond yields rise, they become more attractive as an investment relative to equities. In fact, many equity valuation models, like the Dividend Discount Model, discount future earnings at a specified discount rate. As interest rates rise, the present value of those cash flows decreases.

The last Pillar, valuation, relates to what John Maynard Keynes called “animal spirits” or what is more commonly called “bullishness” or optimism about the future. The Equity Risk Premium attempts to measure that expected return that investors require to invest in equities instead of less risky bonds.

Fidelity Strategist Jurrien Timmer estimates that the current Equity Risk Premium is 3.5%, well below its long-term average of 5%. This low Equity Risk Premium is evidence of relative optimism about the long-term outlook for stocks, but also means that the market is more vulnerable to shocks.

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