Monetary Economics
What Determines Stock Prices?
Gerald P. Dwyer
Fall 2015
Amazon
Price of Amazon Stock
450
400
350
300
250
200
150
100
50
0
5/15/1997
5/15/2001
5/15/2005
5/15/2009
5/15/2013
Amazon
Price of Amazon Stock
Adjusted for stock splits
6000
5000
4000
3000
2000
1000
0
5/15/1997
5/15/2001
5/15/2005
5/15/2009
5/15/2013
Price of Krispy Kreme Stock
Price
120
100
80
60
40
20
0
4/5/2000
4/5/2004
4/5/2008
4/5/2012
Price of Krispy Kreme Stock
Split‐adjusted price
250
200
150
100
50
0
4/5/2000
4/5/2004
4/5/2008
4/5/2012
Overall Market
December 31, 1984 to December 31, 2014
vwcrspx_84
14
12
10
8
6
4
2
0
1984
1989
1994
1999
2004
2009
2014
Overall Market Dividends Reinvested
December 31, 1984 to December 31, 2014
vwcrspd_84
25
20
15
10
5
0
1984
1989
1994
1999
2004
2009
2014
Overall Market Dividends Reinvested
Proportional (Log) Scale
December 31, 1984 to December 31, 2014
vwcrspd_84
9
0.91984
1989
1994
1999
2004
2009
2014
The Explanations
Theory
Stock Priced Determined by
Random walk Unpredictable changes
Castles in the air Sentiment
Firm foundations
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
pt 1  pt   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
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
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
Better Term: Random Walk with Drift
Overall Market Dividends Reinvested
December 31, 1984 to December 31, 2014
vwcrspd_84
9
0.91984
1989
1994
1999
2004
2009
2014
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
pt 1    pt   t 1
– where the innovation (new part) t 1 is
unpredictable
Castles in the Air
• Stock prices are determined by stories
– Now might say a “narrative”
– Amazon
Price of Amazon Stock
Price of Amazon Stock
Adjusted for stock splits
6000
5000
4000
3000
2000
1000
0
5/15/1997
5/15/2001
5/15/2005
5/15/2009
5/15/2013
Price of Krispy Kreme Stock
Split‐adjusted price
250
200
150
100
50
0
4/5/2000
4/5/2004
4/5/2008
4/5/2012
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 the
theory
Price of Amazon Stock
Price of Amazon Stock
Adjusted for stock splits
6000
5000
4000
3000
2000
1000
0
5/15/1997
5/15/2001
5/15/2005
5/15/2009
5/15/2013
Price of Krispy Kreme Stock
Split‐adjusted price
250
200
150
100
50
0
4/5/2000
4/5/2004
4/5/2008
4/5/2012
Firm Foundations
• A theory that stock prices are determined by
expected future dividends and the discount
rate
dt2
dt3
p  dt1
 ...


t
1  1  2 1  3
– 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
The Explanations
Theory
Stock Priced Determined by
Random walk Unpredictable changes
Castles in the air Sentiment
Firm foundations
Firm’s fundamentals
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
Aggregate Stock Prices
December 31, 1925 to December 30, 1933
CRSP Value‐weighted Index
December 31, 1925 to December 31, 1933
3
2.5
2
1.5
1
0.5
0
12/1925
12/1927
12/1929
12/1931
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
300.0
Ireland
United States
250.0
250.0
200.0
200.0
150.0
150.0
100.0
1/2000
100.0
1/2002
1/2004
1/2006
1/2008
1/2010
2000
1/2012
2002
Spain
300.0
250.0
250.0
200.0
200.0
150.0
150.0
100.0
100.0
1/2000
2002
2004
2006
2006
2008
2010
2012
1/2010
1/2012
Great Britian
300.0
2000
2004
2008
2010
2012
1/2002
1/2004
1/2006
1/2008
Housing Prices
300.0
Canada
United States
300.0
250.0
250.0
200.0
200.0
150.0
150.0
100.0
1/2000
1/2002
1/2004
1/2006
1/2008
1/2010
1/2012
2008
2010
2012
Australia
300.0
250.0
200.0
150.0
100.0
2000
2002
2004
2006
100.0
1/2000
1/2002
1/2004
1/2006
1/2008
1/2010
1/2012
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 expected
future dividends and the discount rate
dt2
dt3
p  dt1

 ...

t
1  1  2 1  3
Fundamental Analysis
• Stock prices are determined by expected future dividends and the discount rate
dt2
dt3
p  dt1

 ...

t
1  1  2 1  3
• 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
Fundamental Analysis
• Stock prices are determined by expected
future dividends and the discount rate
dt2
dt3
p  dt1
 ...


t
1  1  2 1  3
• Factors affecting fair value
– Expected growth rate
– Expected dividend payout
– Risk of firm
– Level of market interest rates
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?
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
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 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