Stock Price and Market Model

Good morning RIPvestors,

welcome to another post in the investing series, where I gradually introduce you to the world of investments and go deep on topics I have some experience with, mainly related to investments in Switzerland.

Here’s the tentative schedule for the series:

[Note: this post is split in several pages because it ended up being very long.]

In this post I’m going to show you my understanding of the stock market and the players involved. My humble goal here – I’m totally NOT an expert this field – is to help you (and myself) in becoming aware of the risks associated with investing in stocks/funds, understanding the basic mechanics behind a stock’s price and avoid common pitfalls like panicking and trying to time the market.

astrobeerEssentially I’m going to throw a lot of mostly useless words at you that probably won’t impact much your behavior as investor. Sadly though, in the world of “risky” investments even few apparently small mistakes can destroy an otherwise good strategy. For that reason – to avoid disasters and better react to bad news – I think it’s useful to build a solid knowledge base. For the same reason astronauts spend more than 90% of their training time facing simulated disasters. The difference here though is that I’m not as good as the thousandth part of an astronauts’ trainer 🙂

Hi RIP, I’m a little bit lost. I’m following you since the first episode and my mood is continuously flipping between enthusiasm and desperation… Can you just tell me how, when, where, on what should I invest??

Relax my imaginary friend, there’s still a long way to go. My goal, by the end of this post, is that you’ll know as much as I am and you’re going to tell me what I should invest into. The rest of the series is just technicalities to implement your strategy. Here we’re going to dig as deep as I’m able to into the realm of the market rules.

Let’s start with the single most important thing to know, and let’s do that by asking a question: What’s in a stock price?

I think it should be intuitively clear why this is the single most important piece of knowledge about the stock market, but let’s assume it’s not. If you understand why a company is evaluated at X and what you’re paying when you buy it, you’d recognize all logical fallacies when taking impulsive decisions. Bullshits like: “everyone should buy X, they are growing a lot!“, “Emerging Markets didn’t grow in last 6 years, you shouldn’t buy” or “The market is high, you should sell” should ring a bell inside you.

So then, what’s in a stock price? Or in general, what’s in a price of anything sufficiently traded in free market model? I said “sufficiently traded” because if the market is not wide you may experience under/over pricing due to lack of knowledge by some of the traders.

In the stock price of a company X in a free and wide enough market is the averaged risk adjusted opportunity cost of the flow of X’s expected returns over time.

What a complex definition! And I made it! It’s mine, mine! Let’s dig deeper.

magicstoneLet’s start with an example: “I want to sell you this Stone. This Stone will produce, out of thin air, 10 Dollars per day. Inflation adjusted, Forever“. How much would you pay for the magic Stone? Let’s for simplicity assume that the 10 dollars per day are the only asset we’ll be owning and that we can’t make any other business decision like trying to become famous by showing to the world that we own a magic object (how cool would it be??).

There’s not a unique answer to this question. But to try to come up with a price I’d do the following analysis: how much would I need to obtain the same cash flow with another known investment strategy? That’s my individual opportunity cost. Let’s assume I’m risk averse, so my default strategy with my money is buying bonds and I’m looking for better alternatives, whatever gives me more than the very low at the moment bonds’ returns. Another potential buyer may be less interested, since they may be running a nice business where every extra dollar they invest on it doubles every year. This potential buyer will be willing to pay less for the Stone, since they need less dollars than me to obtain the same cash flow. Their opportunity cost is higher. If you have a wide market, the opportunity costs eventually reach an equilibrium so do the prices.

Opportunity costs play the stabilizing role of inserting a nice negative feedback loop into the price of everything. If there’s an economic boom and everything is growing 20% each year my opportunity cost is very high so I’m willing to pay less for things. The opposite happens on recessions.

Such a Stone is a good model for a treasury bond, not for a stock. Expected company revenues are harder to predict (mean estimation) and yield very high uncertainty in the prediction itself (variance estimation). The means may drive the price, the variance may alter the opportunity cost. One thing is to have a guaranteed and predictable cash flow over time, another thing is to have a lot of unknowns. Would you rather buy X that earns 5% guaranteed per year or Y that is expected to earn on average 5% per year but may go up and down by up to 90%? Right, volatility comes with a cost. That’s why I added “risk adjusted” component into the price. That’s why you may get a predictable 2% from bonds but expect 6-10% returns (averaged per year over a very long period of time) from the riskier stock market.

Anyway, setting aside opportunity costs and the risk component (variance) the most problematic variables left in our price definition are the unknown expected returns over time.

Here’s where all the magic happens. Why a stock’s price bumps by +-10% after a political news, a quarterly earning disclosure, a company acquisitions, a government maneuver? Well, because the expected returns of the company over time change.

And btw, expected by whom? This is another individual factor. You can try to make your offer for buying a stock based on your personal expectations. It won’t impact the market price though. If your offer is below the market price, none would sell you. If it’s above everyone would buy from you. So what’s the market price? It’s the equilibrium. It’s the average expectations of future returns. It reflects the expected returns over time of the company, expected by the very large population of buyers and sellers. Expected by all the publicly available information about the company, the sector it operates in, the rumors about acquisitions, the hire rate, layoffs, current and past earnings, newspaper headlines, current and future projects… the price of a stock of a company contains the expectations of its future, based on all the publicly available information.

Well, I’m using the word “stock” where I should use “capitalization“, which is stock price multiplied by number of circulating stocks. Not a big issue, the same concept applies. I’m also focusing on stocks instead of index funds but the same rules apply. An index fund in just an aggregation of stocks.

So, let’s say once again, since this is the basic rule of everything about stocks: the stock price of a company embeds the expectations of its future returns, based on all the publicly available information.

“Ah cool… anyway, RIP, when is my stock price raising?

Essentially, it is raising when today’s expectations are better than yesterday’s. Well, not exactly. Meeting expectations should earn you the risk adjusted opportunity cost. In an age where in US people wonders if you should take 5%, someone else aims to 3x risk free guaranteed returns of 2% (i.e. 6%) of a balanced portfolio with other assets categories represented along with stocks, I guess that 6-8% per year is a valid expectation those days, for investments in USD currency at current inflation rate (~1%). In Euro area, with inflation rate close to zero, expected returns may be 5-7% in EUR currency.

Anyway, it’s important to understand that it’s not enough that the company you’re investing in is doing well, it has to do better than expected (or at least as good as expected). This is true in the other directions. If a company is expected to shrink, it may still be worth investing in it. The price already reflects bad expectations and just keeping up or shrinking less than expected may end up in a stock price increase!

Let’s take a look a the implications of this rule:

(click on Next Page)

2 comments

    1. There’s no such a thing as “overpriced” since we have no reference price for anything.
      But yes, you’re right. Investor confidence is high for US market so expectations are high.

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