bromion Wrote:
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> Thanks for the thoughtful reply, bchadwick.
>
> > Now the flaw in one of the earlier posts
> > (bromion’s, IIRC) is that although supply and
> > demand push prices up and down, sometimes
> > increased demand is driven by the fact that the
> > stock represents an undervalued asset that has
> > become recognized, and sometimes it’s just a
> mob
> > exuberance that “yay, stocks are good. Both
> > processes can drive the price up, but in the
> first
> > case, the demand is following the increase in
> > stock value, and in the latter case, demand is
> > simply pushing the price around.
>
> This is a false dichotomy. It doesn’t really
> matter why stock prices move up or down. The only
> reason they do move up or down is perception that
> leads to capital inflows – I buy a stock because
> I believe it will be worth more in the future, at
> which point I may sell it and collect the capital
> gain. Whether my perception is based on solid
> fundamentals or outright speculative mania is not
> particularly germane.
This is the crux of our disagreement. Believing that a stock is going to be worth more in the future is not the only reason to buy a stock. You buy a stock because its expected return is sufficient to justify the risk of owning it. That rate of return may include ZERO capital appreciation and be entirely due to dividend flows. And (barring accounting fraud) those dividend flows are the result of wealth creation.
Buying a stock based on the idea that you will be able sell it for more later is sometimes called the “greater fool” theory, and when everyone subscribes to the greater fool theory, you do get an environment that makes the stock market look more like a ponzi scheme.
>
> > A simple way to see how company wealth
> translates
> > to an improved stock price is to use a dividend
> > discount model. Assume for the moment that a
> > company pays out 100% of earnings as dividends.
> > The stock price reflects the present value of
> that
> > (approximately infinite) dividend stream.
>
> I agree with this, but I did stipulate in the
> original post that I was excluding dividends and
> commissions. Many stocks do not pay dividends, so
> its hard to use this as an argument for the
> aggregate stock market (although I do agree with
> your logic for dividend paying stocks). Also,
> whether a company pays dividends or not, new
> capital is needed to cause the price to rise. The
> only way prices go up is if people bid them up.
> For a sustained price increase that reaches new
> all-time highs to occur, a new all-time high
> amount of capital must enter the stock. The market
> cap is the market cap, anyway you want to cut it.
No, you don’t need new capital to have an individual stock rise. You can reallocate capital by selling from a stock that doesn’t rise and has a lower rate of return than the current stock.
> > Another outcome of the a process improvement is
> > that the company could lower the prices of it’s
> > products to reflect the cheaper production
> costs.
> > In this case, company earnings would not
> > necessarily improve unless the lower price
> > resulted in increased demand. However,
> consumers
> > would then have extra money left over than is
> > availabe for other uses.
>
> This is an economic benefit and a social benefit,
> but it doesn’t directly create wealth in the stock
> market.
I missed that you excluded dividend paying stocks. So is your argument that investment in non-dividend-paying stocks is a zero-sum game?
If a company does not pay dividends, then the book value of the equity will increase, and that means that - at a minimum - the value of a share in liquidation has gone up. The intrinsic value of this share going forward is trickier to compute and has more fuzziness to it, but that doesn’t mean that there isn’t an intrinsic value. Just because we can’t tell exactly where twilight becomes night, doesn’t mean that there isn’t such a thing as twilight or night.
>
> There are several ways
> > they can use this new surplus wealth. They
> could
> > consume more I other goods, pushing up other
> stock
> > prices beacause those companies now have higher
> > revenues.
>
> No. Consumption in and of itself doesn’t increase
> stock prices. Higher consumption and earnings
> growth influences the perception of a stock’s
> value, thereby creating demand for the shares. The
> increase in the share price is a second order
> effect, not a primary effect.
Consumption increases revenues and (assuming the company has a positive net profit margin), therefore earnings. In that case, a dividend paying company stock will be worth more than it was over the long term, regardless of perceptions. Perceptions can grossly overvalue what that worth is, but that’s a separate issue.
>
> They could invest it in the market,
> > which would lower the cost of capital for
> > companies. They could save it in a bank, which
> > would in turn lend it out to support other
> > potentially productive activities.
>
> Again, I see where you are coming from with this,
> but I don’t agree. This creates a positive impact
> on economic growth which is beneficial to society.
> It does not directly impact share prices though
> except through our *perceptions* about what it
> implies for share prices. We can all agree that a
> lower WACC will increase share prices, but it
> doesn’t actually happen unless people bid the
> shares up (i.e., the exchange doesn’t have some
> proprietary formula that includes WACC and results
> in increased share prices automatically without
> capital inflows).
This is the weakest part of my argument, but not especially necessary to the main conclusion. I’d have to think about how the lowering of the cost of capital pertains to real value creation.
>
> > So misvaluation and irrational exuberance does
> > create some zero-sum qualities to stock
> markets,
> > but it is not a true zero-sum game because
> there
> > is an intrinsic value to stocks that does
> increase
> > as the result of process improvements and
> wealth
> > creation.
>
> My point is that the intrinsic value is abritrary
> and that you are assigning meaning to the value
> based on what you define as fundamental value and
> speculative value. I’m saying it doesn’t really
> matter what people are using to determine value
> (if they are determining it at all); the only
> thing that matters is capital flows in and out of
> the stock. This is important, because if no value
> is actually being created, then people who better
> understand what perceptions are driving the market
> (and the reality of the company / product / market
> / situation in question) can profit at the expense
> of other investors.
Intrinsic value can be difficult to calculate, because the relevant risk premiums and the likelihood of various payments are not set in stone, but I can decide whether a company that sells for $10/share and pays me $1 this year, 1.10 next, 1.21 the next, and so on is worth more than taking that $10 and sticking it in treasury securities. If other people don’t like the stock and the price goes down to $9 or even $5, that income stream is going to look even more appetizing, even if the stock price itself has dropped.
—
Going back to the dividend model of a company that found a way to produce stuff more cheaply and didn’t lower its prices so that they could capture the wealth benefit for themselves, what you need to realize is that the only people who really realized the wealth increase were the people who held the stock before the improvement and were holding it until after the efficiency improvement happened. Other than that, it’s all about getting an appropriate rate of return in dividends+capital appreciation for the risk level of the company. By holding the company stock, you are exposing yourself to the gains from any process improvements that the company executes WHILE YOU ARE HOLDING THE STOCK, and this is what - over time, ties stock market gains to the wealth generating process in the economy. You also expose yourself to other risks, but the idea is that over time, efficiency improvements are broadly disseminated and whoever owns the companies who develop them get first dibs on the wealth created.
This is also why the time horizon is important. If you are a trader, these things tend to be zero sum, because the true wealth creation process is probably a very small percentage of daily price variation. If you have long time horizons, you start to capture these benefits more and more, and the daily fluctuations in price start to get discounted as “noise.”
It is true that in times like these, perceptions can influence fundamentals and vice versa - something George Soros calls “reflexivity,” and something I also agree with. This makes intrinsic valuation extremely difficult to do in times like the present, but again, that doesn’t mean it isn’t useful in more “normal” environments.