Monday, November 2, 2015

supply,demand, and fundamental value of assets

There is a sort of investor (who typically regards Warren Buffett as his idol) who insists that the true value of a security is the amount of cash can be expected to spin off, with some appropriate discounting of cash flows that are far off or uncertain.  When deciding whether to buy a stock, the thing to do is figure out this value, and then to buy if the price is much lower than that value, and to sell if it is above that value, and simply stay away if it is in between.  Short-term movements in the price are noise, and should simply be ignored.

There are other investors, more typical of hedge funds or (especially before Dodd-Frank) proprietary trading desks on Wall Street, who do worry about the short-term movements; "The long term is just a series of short terms," they might say, and the more prudent of them will repeat Keynes's dictum, "The market can remain irrational longer than you can remain solvent."  "The price of a stock is determined by supply and demand" is not a view against which it is easy to argue.

It seems as though something "fundamental" ought to enter the demand for a stock at at least some level, but it also seems as though new shelf offerings by companies or even the expirations of lock-up periods should reduce the equilibrium price of the stock.  How do these reconcile?

Modern asset pricing has in some ways moved closer to traditional economics, and in particular the idea that trade should (to some extent) be driven by mutual gains from trade; while many people view financial markets as zero-sum, even in the short-run that is only true ex post; different market participants may have different risk preferences, whether that means more or less risk-averse or exposed to one set of risks instead of another, and at least one socially valuable service of markets is to allow people who own a stock and find that current information implies that it is likely to be correlated with other risks they have to be paired up with people who don't own it who find that its expected return compensates them for any marginal risk it would give to their portfolios.  The value of the asset in this model is in fact the sum of the cash flows it will yield, with appropriate discounts for cash flows that are far out or uncertain — but the appropriate "discounting" depends on each agent's own risk preferences and exposures.  Even if everyone takes a Buffett-style "fundamental" approach, not everyone will agree on which stocks are "overpriced" and which are "cheap"; the various stocks, in equilibrium, will migrate to the people who are best equipped to handle the associated risks, and away from those who are least able.

If a particular stock has a risk-profile that is very different from that of any other stock — if it is not strongly correlated with any other stock, and hedges a risk for which no other stock provides a good hedge — then the agents whose risks have the lowest (signed) correlation with the stock are likely to find it uniquely valuable.  If a stock is fairly strongly correlated with many others available, those will effectively be substitutes (in the demand-theory sense of the word) for it; the demand curve for any particular stock, with the others at fixed prices, will be less elastic; the price of the stock should be relatively insensitive to its own supply.  It seems reasonable to me to think that, with realistic microstructure and transaction cost assumptions, stocks (or just about anything, really) will tend to be better substitutes for each other in the longer-run than in the shorter-run; in the short run, various frictions will more likely gum up the ability of agents to substitute between stocks, so that an exogenous, uninformative increase in supply of a stock will cause the price to drop in the short run (relative to the other stocks) and then tend back toward its previous parity, just compensating the marginal new buyer for the related transaction costs (/ liquidity provision).

Addendum: Related to this is the topic of stock buybacks. Recently some politicians have implied that stock buybacks are a sign of focus on the short-term at the expense of the long-run; if the price of the stock is its fundamental value, though, buying back stock is equivalent to issuing a dividend, and will reduce stock prices relative to what they would have been if the money had instead gone into useful investment. I think the model people have in mind is on some level not dissimilar to the one I've presented here, if perhaps less fleshed out: buying pressure lifts stock prices as people are slow to diversify out of it into similar investments, but ultimately the long-term shareholders are worse off than if real investments had been made instead.

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