Posted by: mbuckley56 | November 15, 2008

Stock Market

So, I know how much Kate enjoys posts about finance, so I decided to keep the trend going. Basically, I hear everyone talking about the stock market, and how eventually it will recover from its massive losses. Everyone says “it will go up, because it always does.” I, like many others, believed that this was most certainly true. After all, over the past 20 years, thats what it has done: gone up and up and up. But, I have come to think that this might not be true. I recently read a paper by Harvard professor John Campbell about the stock market and the future of the stock market. According to John Campbell, and my Capital Markets professor, the long term outlook on the stock market is quite poor. Indeed, if one looks at dividend price ratios, this becomes a very easy conclusion. For over one hundred years, the dividend price ratio has had the same average, around 4.5 %. The ratio always varies from the mean, but always returns to the average. This has shown to be the case in many countries besides the U.S., so it is not a case of “data snooping.” Right now, people believe the stock market has hit rock bottom. Yet, based on the dividend price ratio, the stock market actually is at a high price. The current dividend price ratio of the S&P 500 is around 4%. This means that dividends are lower than price. If mean reversion is a true phenomenon, than the price should fall until the ratio reaches the mean. Some might ask “what about dividends rising to reach the mean.” But, Campbell showed using regressions that the dividend price ratio virtually is always restored by changes in prices, not dividends. So, my question is, how valid is really this theory of mean reversion? I would really like to know, because if I had the right answer I could make some cash. Kate, do you have any idea from your extensive math background? Show me the money.

Michael

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Responses

  1. Oh, why would I tell you? I’m making tons of money… 😉

  2. To make it short, the main reason we’re having the current crisis is because we created too much money through debt. Countries issued too much debt and individuals took on too much debt as well…And as money was created faster than real added value we now have to spend the next 10 years to pay back all that debt…

    But still, without being the driving factor, math contributed to the acceleration of the crisis.
    The credit crunch has been amplified because some thought math had something to do with finance…

    Math can help to quantify, but ultimately stocks are driven by humans and you can predict humans.
    You had to be a fool to believe any of us are following any brownian motion.
    Do you follow a brownian motion ? I don’t.
    And despite this, believing that people follow a brownian motion is the basis of the option pricing model. How frightening…
    Models can just to be used to do some local measuring and you have to remember they only work within their limits, unfortunately reality is much more complex.

    There’s no money to be made out of your intuition about dividend price ratio.
    Your stock will go up if many more are buying that stock, why would they buy it ? If they believe dividends will grow in the future. Why dividends will grow ? If the company was to made much more money than expected. etc… Unfortunately predicting the business of a company or the investor’s reaction to that business can’t be modeled.
    Sorry.

  3. I dont really see what Brownian motion has to do with it. I am not attempting to predict what will happen with individual businesses. Prices of companies should relate to fundamentals, specifically earnings. Therefore, if prices are very high relative to earnings, they should come down, or perhaps there is another explanation. I am not trying to predict what will happen with a stock price in the short term. But, eventually prices should converge to their real values.

  4. Sorry I guess I wasn’t clear, I just mentioned option pricing as an example of the limits of math applied to finance.
    As for your ratio =>
    “if prices are very high relative to earnings, they should come down”
    1. what is a ‘good’ price/earning ratio? is it 3 ? is it 5000 ? is it 0.6 ? you can get historic ratio but why should they be a ‘good’ ratio ? this ratio is an output no an input of the markets.
    2. Anyway, you can get the ‘price’ but I’ll be very interested to know how do you get the ‘earnings’! Know one know what the future earnings will be or if there’s going to be any future earnings…
    (you’ll be given the past earnings but unfortunately future earnings are not a function of the past earnings)

  5. Well historically the d/p ratio is about 4.5% and the e/p typically corresponds to it. You can look at a historical graph of the e/p and see that it is cyclical with a mean of 4.5% over different sub-series within the full time series as well as in the entire time series. The only deviation has taken place in the last 20 years, but as we have seen recently it appears to be correcting to its mean once again. Why would it not be a good ratio? It seems intuitive that prices should relate to the basic fundamental value of earnings. One cannot predict future earnings, and the high p/e ratios might be a function of greater expected future earnings and growth. however, if you read Campbell’s paper you will see that historically the stock market has had little predictive power about future productivity growth. It seems like arguing for a high p/e ratio is like arguing that we are going to have a major breakthrough in nano-technology that will vastly improve our productivity. I don’t think investors think this way though.


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