MonetaryEconomics What DeterminesStock Prices?

Monetary EconomicsWhat Determines Stock Prices?

Gerald P. DwyerFall 2015

Amazon

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Amazon

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Overall Market Dividends ReinvestedDecember 31, 1984 to December 31, 2014

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Overall Market Dividends ReinvestedProportional (Log) Scale

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The Explanations

Theory

Randomwalk

Castles in the air

Firm foundations

Stock Priced Determined by

Unpredictable changes

Sentiment

Firm’s fundamentals

Random Walk• Random walk• A random walk is a series in which future changes are unpredictable

• For example, the stock price tomorrow is not predictably higher or lower than the price today

pt1 pt t1

– where the innovation (new part) t1 is unpredictable– Technically, this price is a martingale but we’ll followconvention and call the price a random walk

– Illustration

Random Walk – Why?• Why would stock prices be a random walk?• Information and stock prices

– Suppose stock prices today reflect all the information available today

– Stock prices tomorrow would reflect all theinformation available tomorrow

• What is the difference between today andtomorrow?– There is news today which provides some newinformation

– The news is unpredictable– This news changes stock prices today

• The change in stock prices is unpredictablebecause the change in stock prices reflects thearrival of news – new information

RandomWalk Theoryand Theory of Efficient Markets

• Random walk theory– The change in stock prices is unpredictable because the change in stock prices reflects the arrival of news – new information

• Efficient market theory– Another name for random walk theory

Better Term: Random Walk with DriftOverall Market Dividends Reinvested

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RandomWalk with Drift• Random walk with drift is a series which has apredictable average change but future changesare otherwise unpredictable

• For example, the stock price tomorrow is notpredictably higher or lower than the pricetoday

– where the innovation (new part) unpredictable

t1 is

p p t1 t t1

Castles in the Air

• Stock prices are determined by stories– Now might say a “narrative”– Amazon


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What Is A Bubble?• There are various definitions

– Theoretical– Empirical

• Empirical– A gradual price rise followed by a fast price fall– Can the fall be predicted?

• Future occurrence• Timing

• Theoretical– A deviation of the price from the price implied by thetheory


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Firm Foundations• A theory that stock prices are determined byexpected future dividends and the discountrate

– where the discount rate δ is the interest rate atwhich future income is discounted back to thepresent

• Can relate the current price to earnings as well

1 2 1 3p dt1 dt2 dt3

...1t

The Explanations

Theory

Randomwalk

Castles in the air

Firm foundations

Stock Priced Determined by

Unpredictable changes

Sentiment

Firm’s fundamentals

Castles in the Air

• Extraordinary Popular Delusions and theMadness of Crowds by Charles Mackay

• Histories of several bubbles– Tulip bubble in late 1500s, Holland– South Sea bubble in early 1700s, England– 1920s in United States

Aggregate Stock PricesDecember 31, 1925 to December 30, 1933

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CRSP Value‐weighted IndexDecember 31, 1925 to December 31, 1933

Returns in New Industries

Recent Financial Crisis

• Financial Crisis of 2007‐2008

Recent Financial Crisis

• Financial Crisis of 2007‐2008• Financial Crisis of 2007‐201?

Housing Prices

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Australia

PVC Farms Outside Atlanta in 2010

Resort in Barbados in 2010

Analyses of Stock Market

• Technical analysis– Analyze past prices to find patterns to determine trades

• Fundamental analysis– Analyze information about a company to determine the fair value of a stock

• Benjamin Graham

– Used by most stock market analysts

Technical Analysis

• Look for patterns in stock prices that help to predict future prices– Complicated– Easy to pursue using a computer

• Evidence– T e chnical analysis does not beat a buy‐and‐hold strategy after paying transactions costs

Fundamental Analysis

• Stock prices are determined by expectedfuture dividends and the discount rate

1 2 1 3p dt1 dt2 dt3

...1t

Fundamental Analysis• Stock prices are determined by expected future dividends

and the discount rate

• Estimate “fair value” and compare to current price– Fair value from formula– If fair value high relative to price

• Don’t buy• Sell if own it• Short sell

– If fair value lower than price• Buy• Don’t sell if own it

1 2 1 3p dt1 dt2 dt3

...1t

Fundamental Analysis• Stock prices are determined by expectedfuture dividends and the discount rate

• Factors affecting fair value– Expected growth rate– Expected dividend payout– Risk of firm– Level of market interest rates

1 2 1 3p dt1 dt2 dt3

...1t

Caveats for Fundamental Analysis

• Expectations of the future are a matter of personal estimate in the present

• Precise figures cannot be calculated fromundetermined data

• “What’s growth for the goose is not alwaysgrowth for the gander.”– How much more should you pay for higher growth?

Malkiel’s Rules forBuying Individual Stocks

• 1. Buy only companies that are expected tohave above‐average earnings growth for fiveyears or more

• 2. Never pay more for a stock than its firmfoundation of value

• 3. Look for stocks whose stories of anticipated growth are of the kind on which (other)investors can build castles in the air

Summary

• What determines stock prices?• Random walk

• Random walk with drift• Castles in the air• Firm foundations

• How analyze stock market?• Don’t bother• Maybe technical analysis

• Maybe intuition• Fundamental analysis

Summary

• Random walk theory consistent with firmfoundations of stock prices

• Changes in prices are not predictable• News determines the changes in stock prices and news is not predictable• A predictable development that happens when anticipated is not news

MonetaryEconomics What DeterminesStock Prices?

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