Sometimes price fluctuations are painful to investors. The DJIA dropped 733 points today. Ouch! Sometimes price fluctuations offer relief to consumers. Crude oil is under $75 per barrel today. Road trip! But all prices send important signals in a free economy that are vital in keeping goods and services flowing where they are wanted.
And economists always have interesting things to say about what prices tell us. Robert Schiller advocates something called behavioral finance which brings psychology into the analysis of stock price movements. Mr. Schiller is not convinced stock prices always reflect all relevant information about matters impacting stock values. He is trying to come up with a better explanation of stock market patterns which incorporates the role emotions may play and what institutions do. Mr. Schiller believes behavioral finance has more explanatory power than that offered by a competing, older theory called the efficient market hypothesis. Burton Malkiel has expounded on the efficient market hypothesis in his book A Random Walk Down Wall Street. This theory asserts all relevant information affecting stock values is more or less reflected in stock prices, and that an implication of this is that one can never (or very rarely) beat the market’s long run average rate of return. A monkey picking stocks by throwing darts at the stock pages will do as well as an expert in the long run.
May the best theory (meaning the one that explains stock price fluctuations most thoroughly) win!
A very intriguing graph that captures some of the issues in this stock price theory dispute is located here, down near the bottom of the page. It shows a measure of price earnings ratio on the horizontal axis and a measure of stock returns on the veritcal axis. The pattern of data points indicate an inverse relationship between these two variables, suggesting that when price earnings ratios are high returns are low. The price earnings ratio of a given stock is calculated by taking its price per share and dividing by some measure of the stock’s per share earnings. P/E.
Looking at this graph it appears that high P/E ratios are linked with lower stock returns. P/E ratios were very high until recently. So, does all this information suggest now is a good time to buy stocks or to invest in something else?
