Sunday 23rd April, 2006

 

We rise and fall

 
 
 
 
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George Orwell’s Animal Farm is supposed to be about the Russian Revolution of 1917: an interplay between the powerful and the masses. It is a socio-political commentary that remains valid today, because it’s a cycle: power corrupts; money buys power—we rise and fall!

But we still have to the make the best use of our skills in our time on this planet! And we love wealth—hence our continuing interest in the promises of the stock market.

Last week we looked at the efficient market hypothesis, today we will examine how stocks are priced.

There are exogenous variables and endogenous variables that determine how the prices of stocks rise and fall on the exchange floors all over the world.

There are four exogenous or independent factors. Three of these refer to policy positions and the fourth is a non-policy variable that treats with potential output or production levels.

The three policy variables are:

1 Fiscal policy, which refers to changes in government spending.

2 Changes in corporate taxation rates.

3 Monetary policy, or money supply.

These four factors then influence what happens internally in the economy—the endogenous factors.

There are about eight outcomes from those external variables that determine how stock is finally priced.

These are:

1) changes in total sending

2) past changes in prices

3) changes in real output

4) changes in real money

5) nominal corporate earnings

6) real corporate earnings

7) expected real corporate earnings, and

8) interest rates.

These are all interrelated, but importantly: changes in real output and changes in prices influence: inflation and real growth, in the economic statistics. The effects of these are changes in interest rates.

The rule of thumb is that when interest rates are going up, stock prices are going down.

Stock prices are largely determined, therefore, by government policy and corporate earnings results, as well as by the investors’ required rate of return.

The required rate of return is considered a proxy for interest rates.

It is thought the value of one stock or the entire market, reflects the expected stream of cash flows to be reaped by investors in accordance with the rate of return that investors require.

In a booming economy it is logical to assume that firms are earning expected or above average returns, in an upward trend, and stock prices are rising.

When stock prices are falling, it is an indicator that firms are earning less than projected, that dividend payouts are lower, and that required returns have not materialised. But interest rates should be on the upswing, because the relationship is inversely proportional.

The caveat in this equation is that of “other things being equal,” but other things are not always equal. And therein lies a risk factor is using classical models.

The value however of using classical models is that history repeats itself, and this is the edge that “first movers” have in the stock market investment game.

Those who understand the cycle of stock market prices and trends are able to make an intelligent guess about how the curve will turn. They can sell when the market is at a peak, rally during a fall, and buy, when stock prices are low.

If they are low, will they get lower? You may need to see what exogenous factors are at play: taxes, government spending, money supply, and production levels.

The moral of the Animal Farm may well be in the inevitability of revolutionary thinking, but real power may well reside with those who understand the cyclical nature of things—we rise and fall.

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