Changes in investor expectations of future cash flows drive stock-price volatility.
Asset prices, by definition, are discounted cash flows. Therefore, prices should change only if investors change their expectations about dividends or returns. Studies have shown that changes in expectations about dividends, or cash flows, do not have a significant effect on prices and that expectations about returns are largely responsible for stock market volatility.
In two recent papers, Gil Sadka set out to examine the relationship between aggregate stock-price volatility and cash flows. Unlike previous studies, Sadka used accounting earnings instead of actual cash flows as a proxy for expected cash flows, and found that changes in expected cash flows have a strong effect on volatility. Sadka also found that there is a negative correlation between expected cash flows and expected returns, which adds to the volatility of the market. For example, during a time of recession, investors tend to avoid risky securities and demand a high risk premium in exchange for purchasing a risky stock. Therefore, the rate of return on such stocks is relatively high. However, because economic growth during a recession is negative, profitability is expected to be low. Since the cash-flow and return components of prices have opposing directional effects on price, the negative correlation between cash flow and return increases price volatility.
Previous studies by other researchers suggested that changes in expected cash flows would not affect investors, since investors could avoid this effect by diversifying. However, Sadka, working with Ray Ball and Ronnie Sadka, found that investors can’t diversify away this effect.
Sadka, Gil, Ray Ball and Ronnie Sadka. “Are Earnings Diversifiable? Implications for Asset Pricing.” Working paper, Columbia Business School, 2006.
Gil Sadka is assistant professor of accounting at Columbia Business School.
Investors and fund managers
You can invest in firms with higher sensitivity to aggregate cash-flow news and earn higher expected returns. However, you should be aware that you face cash-flow risk when purchasing shares in these firms. For example, firms with high book-to-market ratios have better returns than those with lower ratios, but the former also have greater cash-flow risk.