Theories of the Stock Prices

Anticipating changes in earnings precipitates a change in stock prices. According to the theory, an astute investor analyzes the fundamentals of a company regarding its effects on future earnings. When future earnings are expected to rise, the stock price increases in advance of the actual changes in earnings. The belief is that by buying and selling stocks in advance of their changes in earnings, investors will increase their returns. In other words, it would be too late to buy stocks after earnings increases are announced or to sell them after decreases in earnings are announced because the stock price would have already reacted to this news. However, if earnings were expected to continue their growth, investors would continue to buy these stocks.

A fundamental analyst is concerned with the financial characteristics of different stocks in order to find stocks that are undervalued. When the market price of a stock is less than its intrinsic value (a reflection of estimated earnings multiplied by a price/earnings ratio), the stock is undervalued. If the market price is above the intrinsic value, the stock is overvalued. This theory then implies that stock markets are inefficient, allowing for large profits to be made from undervalued securities.

What are some possible reasons that fundamental analysis may not work? Burton G. Malkiel, an economics professor at Princeton University, suggests three reasons in his book, A Random Walk Down Wall Street (1990, p. 124):

1. The information collected by the analyst may be based on assumptions and bad information. The analyst may be overly optimistic about assumptions on future sales, cost containment, and earnings that may not materialize, causing earnings disappointments.
2. An analyst may be missing the mark on value. Analysts may agree that a stock is growing at a certain percentage, but they may be incorrect in their perception of value. For example, some analysts agree that Pfizer is growing its sales into the future because of its pipeline of new drugs still to be released to the market, but their assumptions on the future value of Pfizer’s stock may be incorrect.
3. The market may not value the stock in the same way as the analyst does. For example, Cisco stock is currently trading at a P/E multiple of 26 times (its earnings) with a growth rate of around 11 percent. The market might have viewed the stock as overvalued even though analysts still tout the value of Cisco. Rather than increase in price, Cisco’s stock price decreased, which brought its P/E multiple down from its lofty levels.

Fundamental analysis may not always work and has been refuted by the efficient market hypothesis (discussed later in this section).

Because you have no assurances that stock prices will always move in the same direction as earnings over short periods of time, you might not be able to count on correctly forecasting stock price movements. Moreover, a multiplicity of conditions and factors over and above the fundamentals affects stock prices.

Technical factors, which, unlike fundamental factors, affect stock prices because of conditions within the market. Technical analysis ignores the company’s earnings, dividends, and factors in the economy such as interest rates as the cause of stock price changes. Instead, the focus is on past stock prices, their patterns, and trading volume. By charting these past price movements and volume, technical analysts forecast future price movements. Their belief is that past price patterns will be repeated, which is the basis for their recommendations about when to buy and sell stocks. Technical analysis has little support from the academic investment literature. The academic world not only has not been kind to technical analysis, but technical analysis also has been disdained by supporters of the efficient market hypothesis.

The Wall Street investment community’s two methods for choosing stocks, fundamental analysis and technical analysis, have their limitations, as has been pointed out. Academicians, on the other hand, have their own theories, which they have advanced to explain the movement of stock prices. To recap, the Wall Street fundamental analysts believe that individual investors are totally lost without their recommendations and that investors will always underperform analysts. Academicians, on the other hand, have come up with a number of theories related to the dissemination of information that affects stock prices:

* If information were random, a randomly selected portfolio chosen by throwing darts at the names of stock companies would do as well as a portfolio carefully selected by analysts.
* If information about stocks is disseminated efficiently, stock prices will always be fairly valued.
* The capital asset pricing model (CAPM) states that a security’s expected return is directly related to its beta coefficient (which is its rate of return relationship to the market index).
* Market information is disseminated inefficiently in the stock market, and stocks with low price-to-book ratios show greater returns than high price-to-book ratios.

These theories are discussed in detail in this chapter. By understanding the different theories of stock prices in the market, you will be better prepared to formulate your own investment style in the construction of your portfolio.

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