A New View on How Equity Markets Work

 | Jan 12, 2017 13:29

Originally published by PokfuLam Investments

  • New investment process based on academic advancements in equity research

  • By focusing on explaining how markets set prices, a new pricing model has been developed for the Australian, Asian, European and US markets;

  • Risk can be measured and incorporated in the investment process without the assumption of strong-form market efficiency as required for the use of beta or return volatility.

  • By valuing both the market and the stocks in it, we can manage both top down and bottom up factors to maximise returns and minimise risk.

  • Testing in the real investment world has produced significant outperformance in both Australia and Asia.

h2 ​The Key Issues /h2

​The pricing behaviour of equity markets has been questioned since at least 1929, but despite this, an effective model that explains how market pricing works has not been established to date.

​Fama (1991) confirmed that there had been no change from 1965, and a review of the literature since shows no widely accepted pricing model since.

Without such a model, markets cannot be proven to be rational: a key requirement for equity markets to be predictable, which in turn, is the key prerequisite for the commercial validity of any aspect of the equity business.

​If markets cannot be proven to be rational, then prediction of markets is impossible, and the equity business loses its raison d’etre.

​Therefore, it becomes impossible to estimate expected returns, quantify and analyse risk, to determine what is in prices and what isn’t, and ultimately, to predict markets. As such, the basis of any estimate to date must be subjective, based on an incomplete and untested process.

​Quant has problems because the prerequisite strong-form efficiency assumption suffers from the same problem as rationality.

​Thus, developments in both quantitative and fundamental methodologies demand the establishment of a working pricing model.

h2 ​The Pokfulam Investments Market Pricing Model /h2

​Key to a model is establishing returns inherent in prices. There are only two potential answers: dividends, and/or capital gains. Dividends have been assumed since the 17th century, but nothing has been published on the role of capital gain expectations in influencing prices. Shiller (1981) and Campbell and Schiller (1988) proved that prices MUST contain capital gain expectations by default. They proved that pricing cannot be explained by any rational estimates of forecast dividends alone but didn’t go further to specifically analyse those expectations.

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​Thus, the issue becomes, what level of capital gains are reasonably included in prices at a point in time, and what rationally determines those expectations?

​We have managed to answer these questions effectively by developing a model that explains both a large percentage of the variation in, and absolute levels of, market prices in the Australian, Asian, European, UK and US markets. Importantly, it proves that market pricing is substantially different from corporate pricing, including the widely-used DCF valuation methodology. The long-held assumption has been that there is, or should be, no difference between the market valuation of a listed company versus an unlisted one.

​Our research finds that there is a significant difference between the valuation of traded stocks by stock markets, and traditional (unlisted) corporate valuations. If not, then the explanation of market pricing would be relatively simple.

​A key finding of the research is the consistent behaviour of stocks in the immediate ex-dividend period that has a substantial impact on capital gains. This potentially explains why stocks continue to respond to changes in dividend policy, despite accepted theory (Dividend Irrelevancy Theorem: Modigliani and Miller (1961)) that theorises that dividend policy is irrelevant to market pricing. Given the wide acceptance of this theory, the findings potentially explain (in part) why there has not been further developments in the explanation of capital gain expectations, and market pricing generally.

​By developing a working model, we have been able to also answer the other major question in equity pricing: the measurement and analysis of the Equity Risk Premium at a point in time, at both the market and individual stock levels. This makes equities more predictable than thought possible. Below is a chart of the S&P/ASX 200 price/earnings multiple since 1992 against what our model suggests as the multiple that the ASX200 index should trade on given the fundamentals as defined by the model.