The Three Key Drivers of Stock Market Returns

By: Tim Bennett
Many factors can influence stock prices, but three matter more than most. Tim Bennett reveals what they are in this week’s short video.

The three key drivers of stock market returns

Many factors can be said to influence the price of stocks. However, three are more important than most. Here’s a quick look at what they are and why they matter.

The big three

Over the long-term, these three ingredients tend to dictate returns;

The dividend yield

If we break down the total annual returns from stocks in the key US market over time, we can see how important dividends have been.
Dividends tend to be more stable than the other two components (about which more in a moment) and they impose discipline on managers – the pressure to maintain a solid dividend tends to keep them focused on the cash flow generation needed to support regular payments.
Reassuringly, in the UK market (above, right) dividends have been growing for the best part of 20 years in pound terms. However, dividends are just one part of the story.

Earnings growth

A firm’s ability to grow its earnings is vital to share price growth – without earnings there can be no dividends. We can see the influence of this factor on total returns here;
As a reminder, earnings growth can move share prices via the P/E ratio.
However, there is still an ingredients missing – expectations. This is captured in what is called “P/E multiple expansion” or contraction.

P/E multiple expansion/contraction

Whilst dividend yields and earnings growth rates are known quantities, the third ingredient reflects what investors think will happen to earnings in the future. This can have a big impact on total returns;
The point here is that even if dividends and earnings are static, share prices can move based on what investors think will happen next, positive or negative. It is this that makes investing as much art as science – only by understanding this key third element can investors properly understand recent price movements and, by weighing the contribution of expectations, even predict what might happen next. In short, when column three becomes the dominant one, be on the look-out for other signs that shares may be overvalued, or at the very least, at greater risk of share price volatility.