Financial analysis of stock volatility and leverage

are factored into share prices because they are realities that would be valued as such by bidders for the assets themselves. It is a mistake, | think, to suppose that shares prices would be less volatile if more descriptive of real value underneath. The existence of trends suggests the opposite. Trends would be expected from systematic underreaction to the news, so that reaction catches up later, while systematic overreaction ought to be followed by adjustment in the opposite direction. This gradual rather than immediate digestion of the news would tend to smooth out price response. Trends imply systematic underreaction, not overreaction. Market evidence shows something near that random walk as a usual rule, implying neither systematic overreaction nor systematic underreaction, but with some episodes of the latter. What would the reason be? My first guess would be something delaying the mechanics of price reaction when news is particularly surprising. Our sense of where prices should go right now seems not to get them there until later. Prefect reaction to perfect news ought to mean more price volatility, not less, from day to day. Stocks are more volatile then most assets because most are “leveraged.” Firms may issue bonds, and may borrow shorter-term from banks. Fixed interest on those debt claims is paid first. Shareholders get the rest of net output, which itself fluctuates around expected norms and is sometimes negative. If a firm’s net profit (net output) is one million dollars one year, and one dollar higher the next, net profit will have varied only one ten thousandth of a percent. But if interest payments take up the same million dollars per year, every year, profit left for shareholders will have grown from nothing to one dollar. Its growth rate will have been effectively infinite. If the firm earns two dollars less the year after, it will have to invade capital to pay the interest, and owners take a one-dollar loss. Again the difference is trivial percentage-wise to net profit, but diametric to equity investors. The more fixed debt, the more surprise and volatility in whatever is left for shareholders. The ratio of debt to that remainder, called “equity,” is the leverage meant. Stock in this security sense means the same as shares or equity. Chapter 4 Mill’s Idea 1/11/16 20 HOUSE_OVERSIGHT_011011