Nobel Laureate Robert J. Shiller found in his early research that historical dividends can be modeled as a relatively smooth time series. Moreover, this function can be used to interpolate future dividends with high accuracy. This is depicted in the graph below by the function “PDV, Constant Discount Rate”. The graph is taken from the Journal of Economic Perspectives, Volume 7 Number 1, published in 2003.
What is so significant about this? Finance courses at the top universities teach their students that the value of a stock is the discounted value of all future dividends. Those are stable according to Shiller’s findings. However, the stock market, S&P 500 in Shiller’s research, oscillates like the mood of a manic-depressive patient around the mean and fundamental value of dividends.
Despite some criticism towards Shiller’s methods in this piece of research, it appears that some other forces are at work than rational behavior of market participants. Does that mean that market participants are irrational? It does to some extent. The psychologist Daniel Kahneman found in his pathbreaking research how and when human decision making is prone to errors and biases. His book “Thinking Fast And Slow” is an excellent summary of his lifetime insights into this field. Humans probably tend to get influenced by the environment and especially regarding diffuse topics.
How does this relate to the valuation of the stock market? Feedback loops can develop during stock market appreciations. Friends, relatives, and media communicate investment gains. It is quite likely that some are going to believe the story and buy into the direction of an increasing trend. This is trend enforcing and spreads out like a snowball across other friends and relatives, especially after having successful feedback with one’s own investment.
Robert J. Shiller and George Akerlof explain in their book “Animal Spirits” how they view that psychological factors ultimately drive the economy. They emphasize on feedback processes that drive prices, business cycles, and may even result in bubbles. A few research publications support their view. Positive feedback experiments in laboratory setups were able to reproduce price equilibria distant to their fundamental value. However, we should keep in mind that the world we live in is much to complex to be plugged into any research with all relevant aspects.
Nevertheless, our methods root on evidence that psychological factors can explain valuation excess whereas traditional economics fails to do so. Those factors were probably at work during the tulip mania in the Netherlands, the pyramid schemes in Albania, or the south sea bubble. The future will bring new excesses in areas we probably do not expect today!
The bottom line is that valuations tend to be mean-reverting in the long run. Oscillation around long-run mean valuations develops in trends. We aim to recognize trends with tools from behavioral economics, technical analysis, big data, and common sense. Our main attention is dedicated to cyclical trends, which last months to years.