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But, if so, why volatility in share prices, i.e., why are share prices distributed? Surely, since, in liquid markets, there are always buyers - price should stabilize around an equilibrium point.
It would seem that share prices incorporate expectations regarding availability of willing and able buyers, i.e., of investors with sufficient liquidity. Such expectations are influenced by price level - it is more difficult to find buyers at higher prices - by general market sentiment, and by externalities and new information, including new information about earnings.
The capital gain anticipated by a rational investor takes into consideration both expected discounted earnings of firm and market volatility - latter being a measure of expected distribution of willing and able buyers at any given price. Still, if earnings are retained and not transmitted to investor as dividends - why should they affect price of share, i.e., why should they alter capital gain?
Earnings serve merely as a yardstick, a calibrator, a benchmark figure. Capital gains are, by definition, an increase in market price of a security. Such an increase is more often than not correlated with future stream of income to firm - though not necessarily to shareholder. Correlation does not always imply causation. Stronger earnings may not be cause of increase in share price and resulting capital gain. But whatever relationship, there is no doubt that earnings are a good proxy to capital gains.
Hence investors' obsession with earnings figures. Higher earnings rarely translate into higher dividends. But earnings - if not fiddled - are an excellent predictor of future value of firm and, thus, of expected capital gains. Higher earnings and a higher market valuation of firm make investors more willing to purchase stock at a higher price - i.e., to pay a premium which translates into capital gains.
The fundamental determinant of future income from share holding was replaced by expected value of share-ownership. It is a shift from an efficient market - where all new information is instantaneously available to all rational investors and is immediately incorporated in price of share - to an inefficient market where most critical information is elusive: how many investors are willing and able to buy share at a given price at a given moment.
A market driven by streams of income from holding securities is "open". It reacts efficiently to new information. But it is also "closed" because it is a zero sum game. One investor's gain is another's loss. The distribution of gains and losses in long term is pretty even, i.e., random. The price level revolves around an anchor, supposedly fair value.
A market driven by expected capital gains is also "open" in a way because, much like less reputable pyramid schemes, it depends on new capital and new investors. As long as new money keeps pouring in, capital gains expectations are maintained - though not necessarily realized.
But amount of new money is finite and, in this sense, this kind of market is essentially a "closed" one. When sources of funding are exhausted, bubble bursts and prices decline precipitously. This is commonly described as an "asset bubble".
This is why current investment portfolio models (like CAPM) are unlikely to work. Both shares and markets move in tandem (contagion) because they are exclusively swayed by availability of future buyers at given prices. This renders diversification inefficacious. As long as considerations of "expected liquidity" do not constitute an explicit part of income-based models, market will render them increasingly irrelevant.
Sam Vaknin is the author of Malignant Self Love - Narcissism Revisited and After the Rain - How the West Lost the East. He is a columnist for Central Europe Review, United Press International (UPI) and eBookWeb and the editor of mental health and Central East Europe categories in The Open Directory and Suite101.
Web site:
http://samvak.tripod.com/