Unexpectedly Intriguing!
02 April 2009

Stock Market Chaos Changes in stock prices are largely driven by changes in the expected future growth rate of their underlying dividends per share, which provides the fundamental signal for investors in determining the level of stock prices at any given time as investors absorb new information related to changes in that future dividend growth rate for stocks.

Part of what makes the stock market chaotic, or rather, complex, is that new information that publicly-traded companies release can apply to different points in the future. With dividends typically paid on a quarterly basis, information affecting dividends in each individual quarter looking forward can affect stock prices today, as investors react to information related to future dividend payments expected to be paid out in the current quarter, the next quarter, two and three quarters from now, and even a year or more ahead in time.

Investors collectively take the amount of change that they expect in the future growth rate of dividends per share and apply an amplification factor to it, as dividends per share account for just what the companies believe their stable portion of earnings to be. As a result, investors effectively set this amplification factor to be equal to a value greater than one, which means that the resulting change in stock prices will often be much greater than the corresponding change in the future expected growth rate of dividends per share. Consequently, small changes in the expected future growth rate of the stock market's dividends per share will produce large changes in the level of stock prices.

Things such as the expected future growth rate of inflation, as well as other factors, can also influence the growth rate of stock prices in that they affect the value that investors give to the amplification factor at any given time. Here, the amplification factor can be fairly constant for extended periods, but ultimately it will also vary with time, which adds to the complexity we observe in how stock prices change. Some of these factors, such as inflation, have long durations in their impact on the amplification factor, while others are more genuinely described as noise or natural variation, which is always present.

The bottom line in all this is that if we know the current value of stock prices, which establishes a base from which we can project future changes, and if we know the time-shifted expected rate of change of dividends per share at some point in the future and the approximate value by the amplification factor will modify that signal, we can work out where stock prices will go.

We did that this morning using the level of stock prices as established in the month of March 2009 and using the very latest we know of the time-shifted future expected growth rate of dividends per share as of the morning of 2 April 2009.

Since 2001, we've observed that the amplification factor typically varies between a value of 7.0 and 11.0, and most often between 9.0 and 11.0. Using the base of the average of the S&P 500's closing values for each trading day in March 2009 of 757.13, we've indicated the lower range of where we expect stock prices to go on average in the next three months (between 860 and 890, which corresponds to an amplification scale factor of 7.0 to 9.0). An amplification factor of 11.0 would place the S&P 500 at roughly 910.

We should note that this anticipated change in stock prices is not driven by a rapidly improving business situation for the companies of the S&P 500, but rather, the expectation that the current situation will not further worsen.

We do have a tool in the works that will allow you to run our numbers or test drive your own scenarios, but we're still early in the development phase. We'll keep you posted!

For more background information about our analytical methods, please click the tags at the bottom of this post (the "chaos" one is probably the most relevant!)

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