Do stock prices move too much?
It was a volatile week in the markets.
We saw a large drop in the US market with the S&P500 plummeting by 1.6% on Monday (Tuesday morning our time) and the price of oil drop by 6%.
It’s difficult to reconcile why.
The dominant narrative was that fear has risen around the spread of the delta variant. Regardless, the market subsequently recovered later in the week. If investors were concerned about the delta variant, this fear seemed to dissipate rather quickly.
In our view, we are likely to see more volatility of this kind ahead.
However, we have once before remarked that volatility brings with it opportunity: this week provided a good example.
Volatility and opportunity
Why does volatility provide opportunity?
Worley provides an example. Worley fell by more than -4% on Monday, as the price of oil (Brent and WTI) fell.
We took the opportunity to pick up some heavily discounted Worley shares amidst the commotion.
Shares rapidly bounced back later in the week to end the week where they started.
Was the price move justified? We thought this was unlikely.
The volatility we saw this week prompted us to recall a study in the 1980s by renowned behavioural economist Robert Shiller titled “Do stock prices move too much to be justified by subsequent changes in dividends?”.
Market prices are thought to reflect the expectations of future cash flows, with stock prices rapidly incorporating new information to arrive at a price (this is the foundation of the Efficient Market Hypothesis).
In the study, Shiller asked a simple question: do stock prices move too much?
In doing so he asked the question:
What would a market index look like if an investor had perfect foresight and was broadly able to predict the dividends paid by the market in the future (smoothed over several years)?
Would this index be more or less volatile than the actual performance of the market over that period?
The chart below shows the answer he derived: it is far, far less volatile.
The black line represents the S&P 500 index from 1870 to 1970.
The dotted represents what the investor with perfect information would have valued the index at, at any point, based on future dividends and a constant discount rate.
Source: Shiller (1980)
It follows that the level of volatility seen in the market far exceeds the volatility of underlying cash flows, so something else must be at play.
The missing link?
This work was extensively critiqued with subsequent studies offering variations of different kinds (such as using differing discount rates, assessing market movements relative to ‘fundamental’ surprises).
However, it has been shown on several occasions that the stock market is far more volatile than it would otherwise be expected to be.
Schiller postulated that the missing link may be market participants, not the data, which led to the birth of behavioural economics.
In short, investors are not unbiased, unfeeling, calculating machines (even when we have machines to do the calculating at our disposal!).
“Animal spirits”, cognitive and behavioural biases, fear, greed, these all may influence markets. Markets will move for reasons that we might not make sense of, just like they did on Monday. This provides headaches for some and opportunities for others.
We think these periods of volatility provide an opportunity for patient investors to buy cheap stocks.
In the present environment, much of the market’s focus is on key questions of interest rates, inflation and the impact this will have on asset prices (and justifiably so).
However, we would not be surprised if this is amplified by changes in sentiment and “animal spirits” throwing more volatility our way over the coming months (perhaps less justifiably so).
We will look for opportunities over this period with a long-term view of value and plenty of cash on hand.