George Orwells 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 its a cycle: power corrupts; money
buys powerwe 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 wealthhence
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 economythe endogenous factors.
There are about eight outcomes from those external variables
that determine how stock is finally priced.
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
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
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 thingswe
rise and fall.
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