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Monetary EconomicsWhat Determines Stock Prices?
Gerald P. DwyerFall 2015
Amazon
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Amazon
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Price of Krispy Kreme Stock
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Price of Krispy Kreme Stock
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Overall MarketDecember 31, 1984 to December 31, 2014
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Overall Market Dividends ReinvestedDecember 31, 1984 to December 31, 2014
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Overall Market Dividends ReinvestedProportional (Log) Scale
December 31, 1984 to December 31, 2014
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1984 1989 1994 1999 2004 2009 2014
vwcrspd_84
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
December 31, 1984 to December 31, 2014
0.9
9
1984 1989 1994 1999 2004 2009 2014
vwcrspd_84
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
Price of Amazon Stock
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5/15/1997 5/15/2001 5/15/2005 5/15/2009 5/15/2013
Price of Amazon StockAdjusted for stock splits
Price of Krispy Kreme Stock
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4/5/2000 4/5/2004 4/5/2008 4/5/2012
Split‐adjusted price
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
Price of Amazon Stock
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Price of Amazon StockAdjusted for stock splits
Price of Krispy Kreme Stock
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4/5/2000 4/5/2004 4/5/2008 4/5/2012
Split‐adjusted price
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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12/1925 12/1927 12/1929 12/1931
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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1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/2012
United States
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Ireland
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Spain
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1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/2012
Great Britian
Housing Prices
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1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/2012
United States
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1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 1/2012
Canada
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2000 2002 2004 2006 2008 2010 2012
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
