Howard Marks is the co-founder of Oaktree Capital Management and is one of the greatest investors of all time. His memos to investors offer incredible insights into market cycles and investor behaviour and are one of Warren Buffett’s favourite items to read. In recent interviews, Marks has described a valuable summary of what causes stock market fluctuations through four factors which are discussed below.
Factor 1: The trendline of the economy
Over time, the economy tends to trend upward, primarily driven by productivity improvements. This forms the foundation for earnings growth and ultimately, stock market returns. The trendline for US GDP is shown below.
Factor 2: Actual GDP fluctuates around this trend line due to supply and demand fluctuations
Marks described that GDP doesn’t grow at the same rate each year due to production cycles. For example, a corporation might anticipate a boom year, build a new manufacturing plant, hire thousands of workers and produce to build up inventory for this heightened demand. This process would increase GDP above the trendline. Then, after competitors follow suit and inventory is built up, this demand will be met and production will not need to occur at the same pace. This would cause a correction and GDP would shrink below the trend line. US GDP’s fluctuation around the long-term trend line can be seen below.
To quantify the volatility, the US GDP’s standard deviation of the fluctuation around the trend line was 7% from 1981 to 2021.
Factor 3: Corporate earnings fluctuate more than GDP due to both operating and financial leverage
Business revenue will fluctuate roughly in line with GDP since GDP is the sum of the value of all goods and services produced in an economy. However, operating and financial leverage cause corporate profits to fluctuate more than GDP. Operating leverage is created due to the fixed costs businesses operate with. If revenues drop by 20%, but a business has most of its costs fixed, profits will therefore reduce by much more than 20% and vice versa. Financial leverage is where companies use debt to fund their operation. When debt is used to buy assets and fund growth, profits attributable to shareholders increase by more than revenues since the return on equity increases with leverage. The same is true when revenues reduce since the debt balance and interest expense are fixed.
The S&P500’s EPS standard deviation of the fluctuation around the trend line was 24% from 1981 to 2021, which is above the GDP’s standard deviation. The chart below shows this.
Factor 4: Stock prices fluctuate more than corporate profits due to investor psychology
In theory, stock prices should fluctuate in line with earnings since shares in a business represent part ownership of corporate profits. However, stock prices rise and fall beyond fluctuations in earnings due to investor psychology. Howard Marks explained the following:
These changes in investor psychology create fluctuations that often stray from the fundamental earning power of the underlying businesses. This is because boom periods lead to optimism which leads to more generous valuations and tougher periods lead to pessimism which leads to more depressed valuations.
The S&P500’s standard deviation of the fluctuation around the trend line was 31% from 1981 to 2021, which is above both the GDP’s standard deviation and the standard deviation of corporate earnings measured through the S&P500’s EPS.
Ultimately, Howard Marks explained that economic growth drives stock market returns. However, the magnitude of stock market cycles is driven by investor reactions to fundamental earnings, which themselves fluctuate more than the broader economy due to both operating and financial leverage.
Thank you for reading!
- Howard Marks Interview with St. James’s Place
- Howard Marks Interview with The University of Chicago School of Business
- US GDP, S&P500 EPS and S&P500 Stock Prices attained from macrotrends.net