When the prices of stocks and bonds deviate from their underlying fundamentals, as can be seen in the recent bull run, it is because of the mistakes investors make in their expectations of future cash flows or inflation, according to new research from experts in Wharton and elsewhere.
Price volatility is not due to changes in discount rates, or how investors estimate future profits to determine the present value of assets, according to the article titled “When Do Subjective Expectations Explain Product?” asset prices? by Ricardo De La O, professor of finance and business economics at the University of Southern California, and Sean Myers, professor of finance at Wharton.
Myers recently spoke to Knowledge @ Wharton about their research and how it is advancing the debate on the disconnections between price and earnings. “Here is a new way to determine if stock movements are all irrational behavior, or if they are perfectly rational and we researchers just don’t understand what’s going on and there is something very important that we missed because investors are very smart. Below, excerpts from his interview.
Knowledge @ Wharton: What prompted you to do this research on cash flow forecasting and asset prices, and what did you find?
Sean Myers: There is a big unanswered question in finance, which is that the prices of stocks and bonds seem to move much more than the fundamentals of those assets.
If you look at, say, the S&P 500 earnings or dividends, these move but relatively little over time, while prices [for those stocks] are volatile. If the fundamentals of these assets are relatively stable, why are prices moving so much? Since price should only be the present value of fundamentals, what is causing these price movements?
Since price is the present value of future fundamentals, there are only two possibilities. First, it’s all about the discount rate. Future fundamentals have low volatility so maybe discount rates move and that’s why prices have such high volatility. The second possibility is that people may be wrong about future fundamentals. So even though the actual fundamentals futures are pretty stable, maybe people think they aren’t. Sometimes they think future fundamentals are going to go up and sometimes they think they are going to go down. And maybe that’s what drives price volatility.
These two possibilities imply very different things about what investors think about the future. If you look at the dividend and earnings history and use a statistical model, your expectations should continue to be fairly stable. If people’s expectations are very volatile, it means there is a lag where people don’t agree with what a statistician would predict for the future. Alternatively, people might agree with the statistician, but their discount rates are very volatile. Usually, it’s this last story that people have focused on. We assumed people are good at forecasting fundamentals, so they should agree with the statistician, and then we tried to figure out discount rates.
What our research shows is that this is not the case. In fact, almost all of the price volatility seems to be due to the mistakes people make in their expectations of future fundamentals. When we asked investors and professional analysts about their forecasts for future earnings and dividends, they were much more volatile than a statistical model would suggest.
Essentially, the cause of price volatility can only be one – either expectations of future fundamentals or discount rates. Anything that changes in one of these two factors takes away the other. In a boom, the prices are very high. You can split this price increase in half: either people are more optimistic about future fundamentals or they are using very low discount rates.
We argue in our article that if you measure this optimism in booms then in pessimism [in periods of slump], it explains almost all of the price movement, so there is almost nothing left to explain by discount rates. It’s a simple world where people have almost fixed discount rates, and they value stocks only based on what they think about fundamentals.
What we’re finding is that people’s actual performance expectations tend to be pretty stable over time. Booms and high prices seem to be associated with general optimism about dividends and earnings, and declines seem to be associated with pessimistic views on dividends and earnings. Interestingly, even institutional investors have pretty flat discount rates.
For bonds, we find a similar element where bond yields seem to be largely determined by inflation expectations, which is essentially the fundamental for bonds rather than real interest rate movements or discount rate movements. .
Knowledge @ Wharton: Who did you survey?
Myers: For stocks, we asked professional analysts about their earnings forecasts, then for bonds and inflation, we looked at the Survey of Professional Forecasters (a quarterly survey of macroeconomic forecasts) and the Survey of Consumer Finances of the Federal Reserve.
Refine investment models
Knowledge @ Wharton: Where do we go from here? Will the results of your research lead investors and professional managers to refine their models?
Myers: Yes, it helps refine the models. But the big picture is about how we approach [investment modeling] and what we learn from price movements. The old view assumed that people are very intelligent and that they all know the statistical model of fundamentals. So every time we saw the prices change, we thought that people must know something that we don’t know. We thought there must be some sort of terrible risk during a recession that forces people to charge very high interest rates. And during a boom, we assumed that for some reason the whole world had become very safe, and that’s why the discount rates went down. Whenever the world does not fit our econometric model, we assume that we were wrong and try to figure out that there must be some very significant risks that we have missed.
We argue in our article that when our statistical model of how stocks should be valued is different from what we see in the world, it may be due in large part to mistakes made by people, rather than everyone else. having a good view of the fundamentals and we get the discount. wrong rate. The big theme of our article is that a large part of the fluctuations in stock and bond prices seem to be due to poor valuation rather than variable risk over time.
“People make mistakes, and those mistakes are actually very big and seem to explain almost all the price changes.” âSean Myers
Our article aims to help improve models by saying that people make mistakes, and those mistakes are actually very large and seem to explain almost all of the price variation. For an academic audience, the message is basically that we need to reduce our focus on those discount rate models where we’ve been putting almost all of our attention and instead we need to focus on models of how people actually think about fundamentals. . How do people in the real world think about future inflation? What do they think of dividends? Why are their assumptions about the future so different from our statistical models? Why do we find a consistent pattern of errors over the business cycle? So our research is pushing models to look more at how people form beliefs about the future and make mistakes in those beliefs, rather than trying to find different risk factors that could generate returns.
Knowledge @ Wharton: Your article is timely given the recent rise in the markets.
Myers: Over the past 10 years, say, price-to-earnings ratios have been extremely high, almost higher than they’ve ever been. One statistical prediction is that it will eventually return to normal. We don’t know when, but when it does, it means there will be a long streak of low returns for these stocks. The key question is, do all of these investors know this or are they just very optimistic about the performance of these companies? Do they think they’re going to have great dividends and profits, and they don’t think prices will go down in the future?
It is certainly timely in the sense that we are in a period with very unusual prices. Prices have gone up dramatically, but not fundamentals, dividends and earnings. It’s just incredibly confusing. Either dividends and profits must skyrocket, and then these companies can still produce high returns. Or the fact that prices have diverged so much from the fundamentals means that eventually prices will go down, which would be the story that these prices are incorrectly high [and that] people make mistakes about the future.
Everyone agrees that prices and fundamentals have to come together somehow. They diverged quite far. The question is: are they recovering by falling prices or by very rapid growth in fundamentals?
We find evidence that at least among professional analysts or inflation forecasters it appears to be mostly fundamentals beliefs. People think these high prices are reasonable because we are going to experience very high growth, whereas a statistical model says that you are probably going to be disappointed and these high prices are likely to be followed by low returns.
Knowledge @ Wharton: How does your article represent an advance on existing research on this subject?
Myers: The literature has a lot of theories as to what could be going on. There’s the behavioral finance literature that says people might be making mistakes and that’s what is causing all of these unusual asset prices. The other theory is that people are rational and they don’t make these kinds of mistakes, and instead they know a significant risk that we don’t know, and we have to understand that.
This article basically says: Let’s go test this. When we ask people about their expectations, they seem to fall into the behavioral camp where their expectations make those big, systematic mistakes that seem to drive most prices, rather than people giving us very precise statistical predictions where there has to be some sort. of the risk factor that explains price movements. This is how we get things done. Instead of having a theoretical debate, we can directly ask investors what they think about the future.