God is a Capitalist

Friday, October 18, 2013

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]

Lachmann also endorsed the analysis of volume, a common tool with technical analysts, as a measure of expectations/sentiment in the market:
“A little reflection will show that if in a market a strong increase in demand does not lead to any appreciable rise in price, not only must supply be extremely elastic, but where large stocks are the cause of this elasticity, holders of stocks must have a reason for selling out. They clearly ,will do it only if they have reasons to believe that the present strong demand is not only of an exceptional but of a transitory nature, and that for this very reason price will in the long run not be affected by it. If we apply this reasoning to the capital market, we find that interest expectations are most likely to be inelastic in a situation in which the capital market, that is to say, the majority of holders of securities, does not believe in the permanence of the forces exerting pressure on the market and hopes later on to be able to ‘restock’ cheaply.”[2]
Lachmann was writing about interest rates, but the principle applies to prices in most other markets. If increased demand doesn’t cause a proportional increase in price, that means in econ jargon that the elasticity of supply is high, or put simply, that the supply increases as fast as the demand. But supply will increase so fast only if suppliers think the increased demand is temporary. In the stock market that means that increased volume with little movement in prices indicates that the number of bulls and bears is balanced. Expectations diverge.
The flip side of that situation might be a market in which the volume is light but prices move dramatically. That would indicate a convergence of expectations; most investors are either bearish or bullish. Heavy volume accompanying rapid price changes might indicate that a majority of investors lean one direction but find significant opposition.
Successful investors have known for decades that the prices of stocks are made up of more than net present value (NPV) of future income streams. Investor expectations and risk tolerance contribute to roughly half of the variance in stock prices. Price ranges with support and resistance levels, velocity of price change and volume all assist technical analysis to assess expectations.
BTW, NPV analysis is not as accurate or “fundamental” as economists would like us to believe. NPV requires the investor to 1) forecast future earnings and 2) choose an interest rate to discount those earnings to the present. Neither is completely objective. Few analysts can predict earning for companies out farther than the next quarter. One-quarter-ahead forecasts are trivial; for the most part one needs merely to use last quarter’s earnings plus or minus an error or a moving average. Forecasts beyond one quarter are much more difficult and leave the analyst with a lot of room for subjective fudging to get the forecast he wants. The same goes for the interest rate used to discount future earnings. Analysts will consider many factors and each will place more or less emphasis on different factors. That’s why analyst estimates vary a great deal and most media report an average.

[1] Expectations, 121-122.
[2] Ludwig M. Lachmann, “The Role of Expectations in Economics,” Capital, Expectations, and the Market Process, Kansas City: Sheed Andrews and McMeel, 1977, 77.

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