Animal Spirits: There Is No Link Between Stock Prices And Fundamentals

Johnny HopkinsInvesting BooksLeave a Comment

In the book – Animal Spirits, Akerlof and Shiller discuss why there is no link between stock prices and fundamentals. Here’s an excerpt from the book:

Over the years economists have tried to give a convincing explanation tor aggregate stock price movements in terms of economic fundamentals. But no one has ever succeeded. They do not appear to be explicable by changes in interest rates, by subsequent dividends or earnings, or by anything else.

”The fundamentals of the economy remain strong.” That cliché is repeated by authorities as they try to restore public confidence after every major stock market decline. They have the opportunity to say this because just about every major stock market decline appears inexplicable if one looks only at the factors that logically ought to influence stock markets. It is practically always the stock market that has changed; indeed the fundamentals haven’t.

How do we know that these changes could not be generated by fundamentals? If prices reflect fundamentals, they do so because those fundamentals are useful in forecasting future stock payoffs. In theory the stock prices arc the predictors of the discounted value of those future income streams, in the form of future dividends or future earnings. But stock prices are much too variable. They are even much more variable than those discounted streams of dividends (or earnings) that they are trying to predict.

To pretend that stock prices reflect people’s use of information about those future payoffs is like hiring a weather forecaster who has gone berserk.

He lives in a town where temperatures are fairly stable, but he predicts that one day they will be 150° and on another they will be -100°. Even if the forecaster has the mean of those temperatures right, and even if his exaggerated estimates are at least accurate in calling the relatively hot days and the relatively cold days, he should still be fired.

He would make more accurate forecasts on average if he did not predict that there would be any variation in temperature at all. For the same reason, one should reject the notion that stock prices reflect predictions, based on economic fundamentals, about future earnings. Why?

The prices are much too variable.

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