I'm not sure how to take advantage of this research so I will leave it to greater minds than mine (our loyal and long-suffering readers)
From Knowledge@Wharton, November 30:
When prices of stocks and bonds diverge from their underlying fundamentals, as one might see in the recent bull run, it is because of errors investors make in their expectations of future cash flows or inflation, according to new research by experts at Wharton and elsewhere.
The price volatility is not because of changes in discount rates, or how investors estimate future earnings to determine the present-day value of assets, according to the paper titled “When Do Subjective Expectations Explain Asset Prices?” by University of Southern California professor of finance and business economics Ricardo De La O and Wharton finance professor Sean Myers.
Myers recently spoke with Knowledge@Wharton about their research and how it takes forward the debate on disconnects between prices and earnings. “Here’s a new way to determine if stock market movements are all irrational behavioral things, or whether they are perfectly rational and that we, the researchers, just don’t understand what’s going on and there’s something very important that we’ve missed because investors are very smart.” Below are excerpts from his interview.
Knowledge@Wharton: What led you to do this research into cash flow expectations and asset prices, and what did you find?
Sean Myers: There’s a big, outstanding question in finance, which is that prices both for stocks and bonds seem to move around much more than the fundamentals of these assets.
If you look at, say, earnings for the S&P 500 or dividends, these move around but relatively little over time, whereas prices [for those stocks] are volatile. If the fundamentals of these assets are relatively stable, why are prices moving around so much? Given that the price should just be the discounted value of fundamentals, what’s causing these price movements?
Since the price is the discounted value of future fundamentals, there are only two possibilities. One, it’s all about the discount rate. The future fundamentals have low volatility, so maybe the discount rates are moving and that’s why prices have such a high volatility. The second possibility is that perhaps people make mistakes about future fundamentals. So even though the actual future fundamentals are quite stable, maybe people don’t believe they’re as stable. Sometimes they think that future fundamentals will go up and sometimes they think they will go down. And maybe that’s what drives the price volatility.
These two possibilities imply very different things about what investors think about the future. If you look at the history of dividends and earnings and you use a statistical model, your expectations should continue to be fairly stable. If people’s expectations are very volatile, then that means that there’s a disconnect where people disagree with what a statistician would predict for the future. Alternatively, perhaps people agree with the statistician, but their discount rates are very volatile. Typically, the latter story has been what people have focused on. We’ve assumed that people are good at forecasting fundamentals, so they should agree with the statistician, and then we’ve tried to understand the discount rates.
What our research shows is that’s not the case. In fact, almost all of the price volatility seems to be about mistakes people make in their expectations of future fundamentals. When we asked investors and professional analysts about their forecasts of future earnings and dividends, those were much more volatile than a statistical model would imply....
....MUCH MORE
So, manipulate fear and greed?
