The Irrational Component of your Stock Price
In the short term, emotions influence market pricing. A simple model explains short-term deviations from fundamentals.
October 2015 | by Robert Harris
Investors, as no one should be surprised to learn, don't always act rationally. Their biases, myopia, and expectations of long-term stock performance may not systematically cause share prices to deviate from fundamentals in the long term, but in the short term they can cause shares to deviate from intrinsic valuation levels long enough for some observers to raise doubts about a company's value and strategic direction. In general, such deviations from fundamental valuation levels correct themselves quickly—in around three years for the market as a whole and, typically, much sooner for individual companies. But that's more than long enough to complicate life for managers as they struggle to make tactical decisions on matters such as the timing of mergers or the quantity of equity issuances.
Ideally, if managers understand what is happening when short-term share prices are off, they will be more likely to stick to their long-term strategic plans. One way we've found to muster this perspective involves modifying a fundamental valuation model for the stock market so that the model explicitly measures the effect of investors' behavioral biases about inflation, interest rates, and earnings projections. Changing the fundamental valuation's assumptions in these areas helps managers to recognize the conditions that would be most likely to make share prices for their company and sector, and for the stock market as a whole, deviate from fundamentals.
What holds for the stock market as a whole is likely to hold for sectors and companies as well. Investors tend to anchor their expectations for growth and profitability too much in the recent past and need time to revise these expectations to reflect long-term fundamentals. In the short term the stock market could therefore overvalue (or undervalue) sectors or companies that have experienced strong upturns (or downturns), as investors' expectations tend to overshoot (or undershoot) the fundamentals. From empirical evidence, we know that this is precisely the type of bias that shapes analysts' forecasts for companies in cyclical industries.