Bubbles Zombies and the Dividend Discount Model

All,

Here is a link from one of Ritholtz’s Sunday reads: “BUBBLES SPREAD LIKE A ZOMBIE VIRUS”

From this article: “…investors only care about the future income that they can earn from their investments. In the case of housing, standard theory says investors just focus on the future rent they can earn on a property,…”

If you replace future rent with future dividends this seems analogous to the dividend discount model.

So probably pertinent to what we do.

I leave it to others to comment. I just wanted to use Bubbles Zombies and the Dividend Discount Model in one sentence :slight_smile:

So, what can we learn from this in practical terms for stock portfolios?

Werner,

I would be most interested in what Marc and others have to say. But if I understand Marc correctly, this would be strong support for the use of noise in his systems–as he seems to be doing more and more recently. Further, it might begin to explain how this noise gets disseminated and what behavioral factors cause this noise.

Already, we know that analysts are likely to follow the most recent analyst revision. Maybe not Zombie virus stuff but more the herd behavior that the article talks about. None of it completely explained by the future rental income or the dividend discount model–I think.

Ultimately, one should ask what factors–besides those that are directly traced back to the dividend discount model–to use on a rational basis. If any. To me, it seems that many of those factors get explained after-the-fact and they were not really knowable ex-ante.

So for our ports: do you throw out a factor that works empirically but you cannot explain–yet? Do you research it and try to explain it? Do you ultimately throw it out if you cannot find a story for why it works? Maybe this article provides a small story for some factors that are not explained by the dividend discount model–which I think was the point of the article.

Jrinne,
hm, just wondering…if this article is stating more than the obvious:

Yes, we have discovered factors that work (sometimes)
Yes, we have discovered factors that worked for a long time but stopped working
Yes, we have discovered factors and cannot explain why they work
Yes, we have factors that work/don’t work. We thought we could explain why but the explanation was wrong or insufficient.
Yes, there are bubbles in the economy. We don’t know when they start and when they end and what significance they have for the stock market.

What I am learning from this:
Nothing wrong with trying to find relevant factors for our models.
Just don’t be surprised if they stop working.
And never forget that the stock market is a chaotic beast that defers logic oftentimes.
Just my 2 cents.

Werner,

I agree 100% with what you said. Especially if you add the line: they can stop working even if they are directly explained by the dividend discount model. Not really related to the point of the article, however. These seem to be your (excellent) points.

Are you saying you use no behavioral factors? No earnings estimates? No analysts recommendations? No price targets? No momentum? No short interest? Nothing? Or are you saying you do not believe in bubbles? Maybe you do not believe there was in internet or housing bubble? I don’t understand what about the article you actually disagree with.

Even if you believe in none of that, the price of a stock relative to its calculated value based on the dividend discount model should probably be a foundation of all of our models. Perhaps, seeing it in another context (rent and housing) is interesting.

BTW, I agree 110% with this: “And never forget that the stock market is a chaotic beast that defies logic oftentimes.”

Edit for below: Well said. It would be nice to recognize the next bubble but I probably won’t/can’t.

And another Ritholtz read that makes your point about gauging bubbles: “Is the Market Overvalued or are the Measuring Gauges Broken?” Me, I looking into that rainfall gauge thing. I’m sure that if I optimize it I can make it significant.

Jrinne,
thank you for your comments.

I am using most of the above.
As I said: Nothing wrong with these factors or trying to find better ones. It is a never ending search for a better mousetrap.

I am only saying: Even if we use the “best” factors, they can stop working at any time.
And bubbles are always present/starting/ending. But we don’ know the beginning or the end until after the fact, in hindsight. And we don’t know the significance of the bubbles for the stock market. Therefore, the article is stating the obvious.

In other words: We have to use our - limited - tools and should always be conscious how limited they are and not become over-confident that we finally “explained” stock market movements (by bubbles, factors or anything else).

Back in 2000, the world of high tech was pretty messed up. Companies were being valued based on number of employees/engineers, not on products or potential, certainly not future dividends. In Ottawa, VCs were funding high tech startups with the sole purpose of being bought up, the more employees the better as the buyout price would be higher. I knew of one person that joined a company on a Friday and he became a millionaire the next Monday when the company was bought out. Around that time I got a call from a headhunter wanting to explain the “new reality” to me. He offered me a 25% percent raise plus share options to go to a new company being formed, he didn’t care what my current salary was or what my experience was, only that I was a hardware manager. I turned him down and stayed with the old company. Ultimately, I got laid off six years later, six years older and that much harder to find a good job. How should I have valued the job offer back in 2000? It could have led to riches but was purely speculative. On the other hand, the job I had was steady, kept me employed during the dot.com bust, but didn’t last forever and hence dividends (i.e. paychecks) were limited not infinite. Did I make the right decision? Is this any different than the decisions stock investors make every day?

** I’d like to clarify this question - How should one go about valuing the two options, either jumping to the new company versus staying put? Does a present value analysis pass the smell test in either case.

Steve

And you did . . . much respect!

Yup, you got it.

The Schiller paper from which the noise idea springs spoke of the kinds of conditions that influence noise. Translating to ordinary English (even noise is not a Schiller term per se), and focusing on what’s relevant to us, I’ll sum it up this way: The easier it is to come up with a credible quantitative estimate of valuation, the less influence noise is likely to have, and vice versa. That’s why Tesla is likely to be a much noisier stock than Walmart. extremes like that are self evident. It’s the vast filed in between that makes all this so much fun and opens up opportunities for us. And the real fun is looking for predictable factors within noise. And by the way, we need noise (even WMT isn’t zero). If value could be calculated by everyone with perfect certainty, we’d all come up with the same answer meaning liquidity would vanish form the market since the incentive to trade disappears. z-z-z-z-z