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. 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.
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. 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.
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.
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.
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
Campbell, John Y. 1991. A Variance Decomposition for Stock Returns. Economic Journal 101: 157–179.
Campbell, John Y., and John Ammer. 1993. What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns. Journal of Finance 48 (1): 3–37.
Cochrane, John H. 1992. Explaining the Variance of Price-Dividend Ratios. The Review of Financial Studies 5 (2): 243–280.
Vuolteenaho, Tuomo. 2002. What Drives Firm-Level Stock Returns? Journal of Finance 57 (1): 233–264.
Manuel S. Santos
Miguel A. Iraola
"Market Fundamentals." International Encyclopedia of the Social Sciences. . Encyclopedia.com. (November 20, 2018). https://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/market-fundamentals
"Market Fundamentals." International Encyclopedia of the Social Sciences. . Retrieved November 20, 2018 from Encyclopedia.com: https://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/market-fundamentals
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