Ideas with Impact
UNB Faculty of Management

Do you ever wonder if there is a relationship between stock prices and cash flows? Stock prices are the sum of discounted future expected dividends.  In a conventional view of financial economics, fundamental cash flows, such as dividends, play an important role in driving stock price movements. Surprisingly, as recent empirical evidence shows, almost all variability of U.S. aggregate stock prices (specifically dividend yields or price-dividend ratios) comes from changes in expected returns, and almost none of it comes from changes in expected dividends. That is, U.S. aggregate stock price movements have little to do with changes in fundamental cash-flow expectations, which conflicts with the foundation of financial economics. 

Dr. Chunhua Lan, a finance professor with UNB’s faculty of management, recently published a paper that shows U.S. aggregate stock prices do contain information about expected future cash-flow variations; once one separates business-cycle dynamics of aggregate stock prices from low-frequency dynamics, a strong association between stock prices at business-cycle frequencies and future cash flows appears.  “This finding helps to reconcile the puzzle in the recent empirical evidence that U.S. aggregate stock price movements have little to do with changes in dividend expectations,” she said. “In addition, low-frequency dynamics of aggregate stock prices significantly forecast long-horizon stock market returns.”

“Changing expectations of future cash flows have been considered as an important driver of price fluctuations, which is the foundation for many financial economic theories and empirical studies.  Recent empirical evidence of U.S market-level stock price movements challenges this foundation.”

Lan’s paper, “Stock Price Movements: Business-Cycle and Low-Frequency Perspectives,” was published in the Review of Asset Pricing Studies in 2020. Understanding why stock market prices vary is important for revealing how the financial market works. Her study helps to resolve the puzzle by showing a strong association of cash-flow movements with business-cycle dynamics of stock prices.

“I hope, the evidence of my paper can lay an empirical foundation that helps to improve or enrich theoretical works about price movements.”

While the method used to separate business-cycle dynamics is not new, Lan suggests, “The interesting thing is to link different components of aggregate stock prices with cash flows and returns and find interesting evidence to resolve the puzzle.”

Lan joined the faculty of management in 2018 and teaches courses in finance and quantitative investing.

Dr. Chunhua Lan’s recent publication in Review of Asset Pricing Studies looks at why stock market prices vary by showing a strong associate of cash-flow movements with business-cycle dynamics of stock prices.

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