Monetary Economics What Determines Stock Prices? Gerald P.Dwyer Fall 2015
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1 Monetary Economics What Determines Stock Prices? Gerald P.Dwyer Fall 2015
2 Amazon 450 Price of Amazon Stock /15/1997 5/15/2001 5/15/2005 5/15/2009 5/15/2013
3 Amazon 6000 Price of Amazon Stock Adjusted for stock splits /15/1997 5/15/2001 5/15/2005 5/15/2009 5/15/2013
4 Price of Krispy Kreme Stock 120 Price /5/2000 4/5/2004 4/5/2008 4/5/2012
5 Price of Krispy Kreme Stock 250 Split adjusted price /5/2000 4/5/2004 4/5/2008 4/5/2012
6 Overall Market December 31, 1984 to December 31, vwcrspx_
7 Overall Market Dividends Reinvested December 31, 1984 to December 31, vwcrspd_
8 Overall Market Dividends Reinvested Proportional (Log) Scale December 31, 1984 to December 31, 2014 vwcrspd_
9 The Explanations Theory Random walk Castles in the air Firm foundations Stock Priced Determined by Unpredictable changes Sentiment Firm s fundamentals
10 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 p t 1 p t t 1 where the innovation (new part) t 1 is unpredictable Technically, this price is a martingale but we ll follow convention and call the price a random walk Illustration
11 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 the information available tomorrow What is the difference between today and tomorrow? There is news today which provides some new information The news is unpredictable This news changes stock prices today The change in stock prices is unpredictable because the change in stock prices reflects the arrival of news new information
12 Random Walk Theory and 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
13 Better Term: Random Walk with Drift Overall Market Dividends Reinvested December 31, 1984 to December 31, 2014 vwcrspd_
14 Random Walk with Drift Random walk with drift is a series which has a predictable average change but future changes are otherwise unpredictable For example, the stock price tomorrow is not predictably higher or lower than the price today p p t 1 t t 1 where the innovation (new part) unpredictable t 1 is
15 Castles in the Air Stock prices are determined by stories Now might say a narrative Amazon
16 Price of Amazon Stock 6000 Price of Amazon Stock Adjusted for stock splits /15/1997 5/15/2001 5/15/2005 5/15/2009 5/15/2013
17 Price of Krispy Kreme Stock 250 Split adjusted price /5/2000 4/5/2004 4/5/2008 4/5/2012
18 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 Adeviationof the price from the price implied by the theory
19 Price of Amazon Stock 6000 Price of Amazon Stock Adjusted for stock splits /15/1997 5/15/2001 5/15/2005 5/15/2009 5/15/2013
20 Price of Krispy Kreme Stock 250 Split adjusted price /5/2000 4/5/2004 4/5/2008 4/5/2012
21 Firm Foundations A theory that stock prices are determined by expected future dividends and the discount rate p d t 1 d t 2 d t 3 t where the discount rate δ is the interest rate at which future income is discounted back to the present Can relate the current price to earnings as well
22 The Explanations Theory Random walk Castles in the air Firm foundations Stock Priced Determined by Unpredictable changes Sentiment Firm s fundamentals
23 Castles in the Air Extraordinary Popular Delusions and the Madness 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
24 Aggregate Stock Prices December 31, 1925 to December 30, CRSP Value weighted Index December 31, 1925 to December 31, / / / /1931
25 Returns in New Industries
26 Recent Financial Crisis Financial Crisis of
27 Recent Financial Crisis Financial Crisis of Financial Crisis of ?
28 Housing Prices United States Ireland /2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/ Spain Great Britian /2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/2012
29 Housing Prices United States Canada /2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/ /2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/ Australia
30 PVC Farms Outside Atlanta in 2010
31 Resort in Barbados in 2010
32 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
33 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
34 Fundamental Analysis Stock prices are determined by expected future dividends and the discount rate p d t 1 d t 2 d t 3 t
35 Fundamental Analysis Stock prices are determined by expected future dividends and the discount rate p d t 1 d t 2 d t 3 t 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
36 Fundamental Analysis Stock prices are determined by expected future dividends and the discount rate p d t 1 d t 2 d t 3 t Factors affecting fair value Expected growth rate Expected dividend payout Risk of firm Level of market interest rates
37 Caveats for Fundamental Analysis Expectations of the future are a matter of personal estimate in the present Precise figures cannot be calculated from undetermined data What s growth for the goose is not always growth for the gander. How much more should you pay for higher growth?
38 Malkiel s Rules for Buying Individual Stocks 1. Buy only companies that are expected to have above average earnings growth for five years or more 2. Never pay more for a stock than its firm foundation 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
39 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
40 Summary Random walk theory consistent with firm foundations 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
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Stock Market Fluctuations Trevor Gallen Spring, 2016 1 / 54 Introduction Households: Want to be able to save Want higher interest rates (risk held constant) Want their funds to be liquid Firms Want to