Stock prices go up and down all the time, and for lots of reasons. Partly they are driven by real economic or company specific news. If a company makes more money than predicted, we would expect its shares to rise. If the economy is doing worse than forecast, we think that most stocks will fall. However, often (maybe mostly) stock prices go up and down based on emotion and poor reasoning. One Liberian with pre-existing Ebola takes a plane to Texas and the market dives. That’s the part of the market that is more dependent on psychology than economics.
Notwithstanding all the psychologically driven movement, there is a sound methodology for determining if the price of a company’s shares is too high or too low. It is, logically enough, based on the value of the company’s expected earnings going forward, adjusted (or discounted as economists say) for the current rate of interest. Of course we don’t know how much a company will earn in future years, but we do have one very important clue: the dividend the company pays. Companies hate to cut their dividends, and do so fairly rarely. If a company keeps raising its dividend, it is a pretty good bet that its earnings will be rising at about the same pace.
The graph below shows the progress of the S&P 500 index (the squiggly line), and the dividends paid by S&P 500 companies (the straighter line). As you can see, over time the two lines move pretty much in concert.
