Ideas with Impact
UNB Faculty of Management

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, in the U.S. stock market almost all variability of aggregate stock prices comes from changes in expected returns, and almost none of it comes from changes in expected dividends. This prevailing empirical evidence in the U.S. market, that aggregate stock price movements have little to do with changes in fundamental cash-flow expectations, conflicts with the foundation of financial economics. UNB finance professor, Dr. Chunhua Lan, recently published an article in the Journal of Empirical Finance that examines whether the preceding puzzling pattern of price driving forces in the U.S. market extends to other global stock markets.

Lan’s article, “Stock price movements: Evidence from global equity markets,” studies annual stock-market index data ending in 2020 of 30 countries (area) in the G-20 and OECD group and suggests that both changes in expected dividend growth and expected returns play an important role in driving stock market price fluctuations in the most of these global markets. 

“This finding suggests that unlike in the U. S. market, aggregate price ratios in many other countries indeed contain rich information about changes in expected cashflows,” she says.

Her article further reveals interesting and diverse term-structure patterns of dividend growth predictability and return predictability across countries. 

“In the majority of international stock markets, return predictability becomes stronger as investment horizon increases, whereas dividend growth predictability dissipates. This predictability evidence suggests that although short-term driving forces of aggregate stock price movements in many countries likely differ from those in the U. S., long-term driving forces are similar.”

That is, over a short term, stock market prices fluctuate due to expected cashflow variability in most global markets, rather than wandering on news of their own future values as in the U.S. market; over the long term, expected cashflow variation diminishes and most price fluctuations come from expected return variability.

Why do aggregate stock prices contain rich short-term cashflow information in many global markets but not in the U.S. market? Lan suggests dividend smoothing and country-level disclosure and investor protection are two important factors affecting the potential for using aggregate stock prices to anticipate future cashflows. 

“Smoothed U. S. aggregate dividends after WWII disconnect dividend payments with price fluctuations. More disclosure and stronger investor protection in the U.S. allow U.S. firms pay dividends in response to more permanent earnings changes, thereby diminishing the cashflow content in aggregate stock prices.”

Understanding why stock market prices vary is important for revealing how the financial market works. Changing expectations of future cash flows have been considered 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. 

By providing evidence that changes in both expected dividend growth and expected returns drive prices in many global stock markets, this article shows the puzzling U.S. pattern is not representative in global stock markets. This article also provides underlying economic mechanisms to explain why the patterns in the U.S. and other markets differ. 

“I hope, the evidence of this paper can lay an empirical foundation that helps to improve or enrich theoretical works about price movements in global stocks markets,” says Lan. “The heterogeneity in global stocks markets provides an important and rich data set to improve our understanding of various financial economic patterns.”

Lan joined UNB’s faculty of management in 2018 where she teaches finance courses in the BBA, MBA and MQIM programs. Her research interests include the determinants of asset prices and their dynamics and the investment behaviour of institutional investors and the impacts of their behaviour on financial markets.

Learn more about Dr. Lan’s teaching and research activities.

Learn more about UNB’s faculty of management.