Question

Why does the substantial correlation between one year’s stock price change and the change in next year’s corporate earnings support the idea that stock prices change to reflect expectations about the future?

Answer 1

Substantial correlation between one year’s stock price change and the change in next year’s corporate earnings support the idea that stock prices change to reflect expectations about the future.Same is being discussed in this context.

As institutional ownership increases, stock prices should reflect more current period information that is expectation of future period earnings. We find that the extent to which share prices lead earnings is positively related to the percentage of institutional ownership. This result holds after controlling for various factors that affect the relation between price and earnings. It also holds when we control for endogenous portfolio choices of institutions ( institutional investors may be attracted to the firms in better information environments where stock prices tend to lead earnings). Further, a regression of stock returns on order backlog, conditional on the percentage of institutional ownership, indicates that institutional owners place more weight on order backlog compared with other owners. This result is consistent with institutional owners using non-earnings information to predict future earnings. It also explains, why prices lead earnings to a greater extent .

When someone buys a stock, he is purchasing a proportional share of an entire future stream of earnings. That's the reason for the valuation multiple. This is the price what the person is willing to pay for the future stream of earnings.Part of these earnings may be distributed as dividends and rest will be retained by the company for reinvestment. We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.

In the short time when stock returns are measured over periods of days or weeks, the usual issue against market efficiency is that some positive serial correlation exists. But many studies have shown evidences of negative serial correlation ,that is, return reversals over longer holding time.future stock prices are somewhat predictable on the basis of past stock price patterns as well as certain “fundamental” valuation metrics. Moreover, many of these economists were even making the far more controversial claim that these predictable patterns enable investors to earn excess risk-adjusted rates of return.

Now It can be concluded that the idea about the changes of Stock Prices reflect the Future expectation is supported by the Substantial Correlation between Stock Price change and the change of next year's corporate earnings.