Wednesday, May 21, 2008

Asset Prices as Driver of Fundamentals

This is quite random stuff, and like everything else, completely wrong.

I am increasingly getting convinced that the price of an asset (like a stock) impacts its fundamentals. Traditional economics will say that price is determined by supply and demand,
i.e. P = f (S, D).

I think
P = f (S, D, P).

And to refine it even more:
P+ = f (S, D, P+)
P- = f (S, D, P-)

i.e. the probability whether the next move in price is up is determined whether its last move was up or not, and vice-versa. (This is not a good mathematical representation of what I have in mind, but lets have it like that for the time being)

This is what price momentum is. Essentially, what this implies is that any fundamental analyst who ignores price momentum because it is a hobby of technical analysts doesn't appreciate that prices impact fundamentals, and misses out on an important variable in his/her thought process.
This will also explain why markets can deviate from prices determined solely by supply-demand arguments. If markets were efficient, there shouldn't be boom and busts. That is clearly not the case.

In the new framework laid out above, markets will necessarily go in a boom-bust phase, depending on the price momentum. A boom-bust market is an efficient market, not an inefficient one.

Isnt this what Greenspan is saying? Boom and bust is a part of capitalism and markets. You can either have a state controlled communist society where prices don't change and neither does anything else (except misery which keeps on increasing) or a market based society with its episodes of booms and busts. There is no third alternative.

1 comment:


That post is the most unusual.