mathgeek2

How Stocks Work: Four Viewpoints

I think the essential thinking is all here;

If markets are correctly anticipating future cash flows and the appropriate forward discount rate, then the TSR (total shareholder return, including dividends and appreciation) should be exactly equal to the risk free rate plus a market equity premium.

Of course, this is impossible in practice, and so share prices go up and down all the time (in some cases dramatically) as the market shifts its perceptions of likely future cash flows and the future path of discount rates. This can create different levels of returns for shareholders, depending on the period of time in which they held their shares.

Again, what matters is not the changes in any of these factors, but any changes relative to the expectations currently priced in the market. When I am thinking about an investmet option, one of the things I like to do is to understand the expectations (future earnings, discount rate, etc.) that appear to be implicitly priced into the stock. If I belive these expectations to be overly pessimistic, this is a buying opportunity. If the expectations are overly optimistic, this is a selling opportunity.

In fairness, there is one big problem with this methodology; While I do think it works in the longer run, in some circumstances (recent times are a great example) Market participants stop making decisions on the value of the asset and start making decision primarily on market momentum.... in other words, a version of the greater fool theory. Is my internet stock circa 1998 really worth $20? Maybe not, but I;m willing to bet someone else will buy it in a year at $40 regardless. Is my bank stock circa 2008 really worth less than the cash on the bank's books? Maybe not, but I bet I can short it today and buy it back tomorrow for half the price regardless.

When a substantial portion of the market becomes driven by players who are basically making "greater fools" bets, it is extremely difficult to know where things will go; Prices will keep going in one direction until not enough people think that there are enough greater fools left, and then they will tend to severely correct.

Only in the longer run can you expect economic reality to overwhelm these kind of issues; At some point the economcs can't be defered any longer (e.g. it becomes patently obvious to everyone that shares are over or undervalued relative to basic economics) and so the market will adjust back to a more fundamental driven prices. Of course, you can go broke waiting for that to happen...