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Four Reasons Why Economists Are Wrong About Asset Prices

Dec 15, 2017

Commentary: The behavior of asset prices is a critical issue for individual investors. Movements in stock, bond, and real estate markets can have life alternating consequences for savers.

The price of  an asset should reflect the underlying fundamental value and changes in asset prices should arise from changes in fundamentals . For example, the price of Facebook stock should be the expected value present value of future dividends. If Zuckerman announces a new initiative that will increase future profits, that should be quickly incorporated into Facebook’s stock price. If the price rises, that’s a signal to Zuckerman that he has made the right decision and should forge ahead; if the price falls, perhaps Zuckerman should revise his plans.

That is the way it is supposed to work, but does it actually work that way? A new review by two World Bank economists Stijn Claessens and M. Ayhan Koses, which looks at hundreds of different studies, finds that the answer is “no”.

Claessens and Kose paper is massive with more than 30 pages of references, but in their conclusion, they organize their findings into several smaller bite size bits that are more easily understood.

First, asset prices are too volatile that would be suggested by the volatility of the underlying fundamentals. For example, people overreact to financial news causing the financial news to have an exaggerated effect on U.S. stock and bond prices.

Second, investment and consumption respond differently to changes in asset prices than would be predicted. A rise in stock prices, for example, should trigger business expansion. But this doesn’t happen. At the same time, households overreact to changes in asset price, especially home prices, by increasing their consumption by more than would be expected.

Third, asset prices are of limited value in predicting economic activity. Because asset prices should reflect the underlying fundamentals, a rise in, say, stock prices should foreshadow a rise in economic activity, but this doesn’t always happen.

Finally, asset prices tend to have a co-movement greater than would be expected from their fundamentals. Of course, to businesses operating in the say industry, say Coke and Pepsi, share fundamentals. The general upward trend in cola consumption has benefited both, for example. So you would expect Coke and Pepsi shares to move together and they do, but by more what would be predicted.

So the basic conclusion is that economist’s standard model of asset markets doesn’t. Of course, professional economists who work in this area have known this for a long time. At least three recent Nobel, including this year’s, have been about misbehaving asset prices. And we economists have developed a number of alternative theories.

Many of these alternative gives special prominence to access to finance capital. Why don’t businesses expand more rapidly when their stock price rises? Because they can’t find a bank to lend to them. Why do household consume more than predicted when housing prices rise? Because now they have an asset that can serve as collateral.

What are the implications of all this for individual investors? That markets are too volatile and that stock prices are highly correlated makes the recommendation that investors should diversify even more important. That stock prices don’t reflect fundamentals makes stock picking more difficult, reinforcing the recommendation that small investors should buy and hold, and not try either prick stocks nor time markets.

Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He has taught money and banking for more than 30 years. The opinions expressed may not be shared by the regents and administration of NMSU. Chris can be reached at chrerick@nmsu.edu