Stock markets translate expectation and confidence into real money. Unfortunately, we don't have reliable mathematical models expectation and confidence. Therefore, we don't have a quantitative model for computing "market values" of assets. Leverage amplifies the effect of mood changes by the investors. It adds additional complexity to a system that we are in no position to model.
What should the price of a share be?
To determine a share's worth, one solves the net present value of all the expected revenue. This includes the future dividends plus the expected selling price. This is the approach in classical economics.
For simplicity, suppose a share does not pay dividends. Then the price depends solely on the resale price in the future. The value of a share today is the net present value of the price tomorrow. The price tomorrow can be derived from the price the day after, and so on. At least that is the theory. According to this theory, when there are no dividends, a stock's resale price depends entirely on the collective valuation by all the participants in the market.
It is worth noting that adding dividends does not change the picture. All it does is to add a constant to the valuation.
Where the theory collapses
Classical economics attempt to model asset prices mathematically. Unfortunately, we don't have a mathematical model for everything. Crucially, in this case, we don't have reliable mathematical models about investors. We don't know how everybody in the market thinks, either individually or collectively. Even if we assume that everyone knows everything in the company, we don't know how they value them. We may know that a company has secured a $100 million order, but we don't know how the investors would value this order in the company's share price.
If we cannot quantitatively study the way that the investors thinks collectively, then we have no scientific estimation of tomorrow's price.
Share prices reflect expectation and confidence
Apart from dividends, a company's share price reflects investors' expectation and confidence. This includes negative confidence, which may reflect worries and fear.
The stock market effectively turns expectation and confidence into real money.
Expectation can change overnight. There is no limit in how much confidence one could have in a company. That means there is no limit in how much a company's wealth is valued. The dot com bubble is a good example. Companies could have their share prices redoubled before they receive the first revenue.
Confidence can evaporate in a flash. So can wealth. All the big crashes are good examples. Markets enables bubbles. The tulip mania in the 1600s is an early example.
Herding behaviour
Both expectation and confidence are infectious. Fear spreads particularly fast. The change of moods have direct effect on share prices. The spreading of behaviour is called herding. The media has more say than the economists in herding. Therefore, naturally, the media has more influence than economists on the stock prices. Many people know that.
What is the value of the public's mood?
Some economists insist that media influence is nothing more than noise. Noises may affect stock prices, but prices will be adjusted to their true values in the long run. The question is: what is the true value? This is equivalent to asking "what is the correct expectation to a company's future?" and "what is the correct level of confidence to a company?" In other words, "what is the value of the public's mood?". How many of us believe that we can answer that?
Remarks: what has changed?
The fact that markets turn expectation and confidence into money is not new. Gold has been a good example. The fact that wealth can be created and evaporate in a flash in not new. What is new is the increase in leverage. Derivatives, such as futures, options, contract for difference, etc, increase the investors' leverage. Without leverage, an investor with $1 was able to invest $1. With leverage, he can invest $10, say (sometimes a lot more). Leverage amplifies the change in moods. They help to create boom and bust.
What has also changed is the media. The Internet helps to spread news wider and faster.
Computer trading helps to move the market faster. A human trader takes seconds, if not minutes, or days, to react to market changes. Computer programs can react to changes in milliseconds.
All these changes amplify the impact of the moods.
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