Wall Street still likes Quants

Part 4 of the series on sock pricing to which I referred just went live:


My opinion is that the price of a stock is a final sum of all the market participants, each using a different strategy.

One such strategy is value investing (the value of the stock is the discounted sum of all future cash flows, and you should buy underpriced stocks and sell overpriced stocks). Even accounting for differences in estimation of future cash flow, if everyone were value investors, the stock market would have far lower volatilaty. Clearly not every one is a value investor, because stocks fluctuate wildly even when then is no news.

Take another strategy: momentum investing. I view this as: “The upward trend in interest and stock price is strong, and I have reason to believe the trend will continue. I have no idea what the underlying business is worth, and I don’t care.” Clearly some people invest money this way. But just a clearly, not everyone invests this way, because otherwise some stocks will shoot to the moon and keep going up and never correct, and other stocks should go to zero and never recover.

I don’t thint there is a single correct way to model the stock market, because in reality we all are the stock market, and we all have different strategies that in turn drive the stock price.

Yes, absolutely.

Evaluating the discounted sum of all future cash flows is a widely-used and well-recognized practical way to get at the theoretical core of value (the present value of future dividends) since cash flows is a source from which dividends can be paid. And yes, buying a stock that is thusly undervalued is a well-recongoized way of effectively aligning the stock price with the present value of future dividends (in theory) and any practical-real-world proxy.

And yes, not every one is a value investor. A Fisher Black quote I used in the TalkMarkets peace that went up earlier today goes further and points out that such non-value investors don’t merely exist; their participation is critical to establishment of a healthy liquid market

Again, yes.

Note, though that some momentum strategies succeed and others don’t (this is easy for anyone here to verify on p123). The question is what makes for the difference.

Logic tells us that a stock’s performance yesterday (or in the last week or the last month, etc.), cannot influence the stock’s perform,once today. But the perform,acre yesterday did not occur in a vacuum. There are reasons why demand related to supply in such a way as to drive the price, let’s say, upward. If those same motives continue today, we have very reason to assume the stock will stay on trend and continue to do well. Momentum investing ultimately depends on the persistence of the factors that caused the stock to do what it did in the past. We can model that directly, for example, by building models that combine momentum with other things. Or we might do that indirectly, as by searching for price patterns that imply investors are acting in particular way (the way technical indicators/strategies get created).

The point I’m making here and which is explained in the four-part TalkMarkets series is that while not everybody calculates and invests based on the present value of expected future dividends (actually, in the real world, I doubt anyone actually does that), successful strategies are those that one way or another point you in the direction of that core.

And again, yes absolutely.

Because the present value of future dividends is not something we can credibly calculate, we rely on a variety of ways that point us in the general direction, a variety that seems infinite as each investor will likely develop multiple approaches.

My point, however, s that strategies that cannot logically be connected to that core are the ones most likely to cause trouble. You gave a personal example by cutting the difference between momentum stocks that “shoot to the moon and keep going up and never correct, and other stocks should go to zero and never recover.” The difference lies in the reasons why the stocks shoot up. Successful momentum investing taps into this and to do that,one must understand the reasons why stocks behave as they do.