Dollars and Jens
Tuesday, August 25, 2015
finance: prices and fluctuations
The stock market has been doing something, and if you care you can go read about that elsewhere, but it has led to some discussion of why prices of financial assets bob around at times, and even the relatively informed discussion seems a bit narrow-minded.  My own research, such as it is, is based on value that assets gain from liquidity or other effects related to heterogeneous agents, but this post is going to eschew even that, working simply from the basic Lucas asset pricing model that everyone knows and loves:
Price = total expected discounted dividends
Robert Shiller somewhat famously (in certain circles) observed several decades ago that dividends are much less volatile than price, and concluded that markets are irrational.  (This summary is only slightly unfair to him, and, to be clear, I agree with him that markets aren't perfectly rational, but that's quite a leap from the evidence he provided.)  When I first saw that, my thought was, "it's not the dividends that are fluctuating; it's the expectations".  It turns out that many — I perhaps overly associate this with John Cochrane, and have been convinced myself now to join their camp — believe that fluctuations in price are driven by that term in between: discounted.

From this last point of view, then, a drop in the stock market is a reflection primarily of investors demanding a higher return than they were demanding before.  One of the reasons for demanding higher returns is higher perceived risk, which can get recursive for agents with short time horizons: if that risk isn't a risk that dividends will be weaker than expected in the distant future, but a risk that other people will be demanding higher returns when you're looking to cash out your position, then it's hard not to imagine that there are likely to be multiple equilibria.  Another reason for demanding a higher return, though, is that it is expected that new investment options will become more attractive in the near future; this especially might mean that the Federal Reserve is expected to raise interest rates, such that short-term bond investments will be more attractive than they have been in the last seven years.

I will note that long-term bonds tend to go up (their demanded yield down) on days when stocks go down and vice versa — expected risk-free returns in general can't be driving day-to-day moves in both bond markets and stock markets, so your very short term fluctuations, insofar as they're "rational", must involve some changes in expectations, risk premia, etc.  In general the arguments for market efficiency work better the longer the time-frame, and daily movements are going to be driven almost entirely by entities that respond to market fluctuations on a daily basis.  If you're wondering why the stock market has been expensive, compared to its recent earnings and historical price to earnings ratios, you can't ignore the yields available in the bond market, and if you think bond prices are going to come down in the next couple of years, you should probably be expecting stock prices to at least stop their climb.

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