Why do stocks in the stock market behave so dynamically?
Alan Jennings, University of Akron, Mechanical Engineering
Wednesday, August 31, 2005
Dynamics of a system describe the potential for it to be controlled. Stocks in the stock market have frequent large fluctuations showing a very dynamic system. This paper will investigate the motivations to the fluctuations of stocks in the stock market.
Introduction
Dynamics
Dynamics is the study of how things fluctuate. The most common example is of a mass connected to a spring. If the spring is stretched and released, the mass will continue to bob until the energy is dampened. Dynamic systems come in many other types too. Dynamic disturbances can cause critical problems. When wheels are off-balanced, high speed travel can reduce steering control. Reducing or controlling system dynamics is necessary to use many systems. Some are for consumer use like fuel injection control. Others are for industrial use like automated manufacturing robotics. Economics could be considered as a way of controlling investments or companies in a way that they produce real profit. A dynamic model would provide predictions, or forecasts, of significance of inputs to the economic system. Economic systems are perturbed daily and economists should know how to control their systems beneficially.
Stocks
Stocks represent an accepted value of a company. A company to gain capital sells ownership to investors who offer capital in exchange for a share of ownership, called stock, in that company. The total price of all the shares sold represents the capital of the company. In the course of business, the assets and liabilities of the company will fluctuate. If individuals feel the value of the company has increased, they will value share of the company higher then what they paid for them. However if they feel the company has lost value, they would be willing to sell the shares for less. Ultimately investors ‘set’ the price of the shares to what they feel the shares are worth.
Some stocks complied together have been used as a leading indicator of the trend of the gross domestic product (GDP)[1]. A leading indicator will predict the economic condition in the near future. Leading indicators are chosen based on the things that are prerequisite to an increase in the GDP. When a company produces more product, it should increase in value. Investors would therefore value their stocks more. In fact if the investor merely believes that a company will increase in value, they will value their stock reflecting the believed potential. Historically, stock aggregates have in fact accurately been a leading indicator but they often indicate more change in trends than the trend actually changed.
Stock dynamics are important on making decisions of when to buy, sell, or hold shares of stock. Rational investors would make those decisions on the basis of getting the most value from their investment. Knowing how the stock will respond to the perturbations, would suggest whether to buy, sell or hold when certain perturbations happen. This is a preliminary form of controlling the dynamics. It is simply using the known dynamics and current perturbations to predict the response over time. Without some guide of future performance, an investor could not rationally invest in anything.
Another benefit of knowing the dynamic behavior is that the system can be perturbed in a rational fashion. Without knowing what effect a course of action will have, how could it be justified? A simple control was stated before. As the investors value the stocks more the price of the stocks will go up. And this can be achieved by increasing their perception in the value or future value of the company. This control is often used today. Companies will report to shareholders and explain that the company is increasing in value or is planning to.
Dynamics will illuminate to companies and investors alike a suggested course of direction. This will make certain suggestions for short term investing and also long term investing. Short term investing will utilize high frequency fluctuations. Long term will follow low frequency fluctuations and trends in the behavior. The time span considered would come from the dynamic analysis determination of fluctuations periods. Also the analysis would suggest possible returns. Having a full dynamic analysis would provide companies and investors a scope of investment strategies and returns.
Why I am studying stock dynamics
My career objective is oriented to analysis, implementing and controlling dynamic systems. Understanding how disparate systems work will give diverse possibilities of development. Future systems could be related from economic perspectives to explain system concepts to an economic minded people. Economic solutions may also offer innovations into conventional systems.
Figure 1: Representative of dynamic behavior of aggragate of stocks.
Shows daily fluctuations and low frequency fluctuations.
The stock market is a very complicated system. Values change hourly and inputs are ambiguous. False inputs and arbitrary fluctuations create noise in the response and input recording. Multiple outputs also complicate the system since some businesses grow during prosperous times while inferior goods decline.
Despite (or perhaps because) these challenges, economic systems are similar to mechanical or electrical systems. The difference is that economic systems are less understood. Similarly, friction is less understood. Many inputs affect how friction will behave and often it will appear random.
Identifying the significant inputs is always the first step to understanding a system. Applying myself to an unusual system will help me identify significant inputs later systems encountered. Often in mechanical systems, inputs are obvious due to the forces created represented in constitutive equations. Not having equations to work with develops my ability to discern and recognize significant input. Inputs can be very common and with friction, thousands or factors could affect behavior. Only the most significant inputs should be considered, otherwise the analysis would be bogged down. The next step would be to know how the system responds to the inputs. This is a detailed and advanced project and is outside the scope of this paper.
Of the many dynamic economic systems, stocks were chosen due to their very responsive nature and they are well known. Anyone has heard of the stock market. The frequency that stocks are reported suggests their instability.
Discussion
Basic analysis
Stocks reflect how a company is valued. Companies compete in the economic realm and so their behavior can be understood in economic terms. Beginning with a simple supply and demand discussion, the principles affecting pricing will be determined. Then opportunity costs will show when companies earn real profit or grow in value. Reason would suggest that this would be reflected in stock values also. Equilibrium results will suggest long term behavior.
Both supply and demand have effects that drive costs. Demand is the measure of how much a product would be bought a certain price. Supply is the measure of how much a product suppliers would produce at a certain price.
If demand were to exceed supply at the selling price, all the product produced would be sold and inventory would decrease. The obvious solution is that price is increased resulting in less product desired and suppliers willing to make more product. This could occur due to an increased demand created by marketing or otherwise. Or perhaps innovation would suggest suppliers make more due to reduced marginal costs. Either way the company has the potential to gain more value then before the disturbance.
If supply were to exceed demand at the selling price, all the product demanded would be sold and excessive product would be inventoried. The obvious solution now is that price is decreased resulting in less product suppliers will produce and demand wanting more product. This could occur due to decreased demand by bad public image or increased costs of production from new taxes or other expenses. Overall the company will sell product at less of a price.
Whenever these disturbances companies raise or lower the selling price, the costs of business change. The principle of opportunity costs is that choosing any one course of action will prevent a number of other courses. The cost of the chosen path is the most that investing could return. When companies are gaining money at greater rates, others with lower opportunity costs will enter the market increasing supply. When companies gain money at reduced rates those with high opportunity costs will leave the field decreasing supply. In a rational economy will easy entrance this will occur until suppliers are earning their opportunity cost and no real profit. In this sense, no investment will earn real profit except when the market is in disequilibrium.
This would suggest that investing for short term during excessive demand is the only rational course of action. Long term investments will only yield their opportunity cost and no more on average.
Pure competition; indistinguishable goods, entrance easy
Monopoly; sole provider, entrance impossible
Oligopoly; few providers, entrance difficult
There’s another; distinguishable goods, entrance fairly easy
Does this make sense?
Looking at reality, short term investing in the stock market is very erratic and foolish. This is often called speculating on the market. Long term investing has shown substantial growth. So even though some basic economic principles would suggest this tip based buying and selling, other inputs are more significant.
Companies want to earn the highest real profit. This is their sole economic purpose of being. If they were to continually create disturbances that increased their demand decreased the costs of supplying, they could continually earn a real profit. This makes real world sense and reflects common business practice. Why would so many companies spend a tenth of revenue to support research and development, unless innovations beyond competition were the only chance of earning real profits. Marketing and advertising is likewise a large industry.
This also offers a better explanation stocks as a leading indicator of the GDP. If stock growth reflected new innovations or more demand, more product will be produced. That is what the GDP measures.
Knowing that companies that continually create positive disturbances will be the most profitable, tells companies what to do and investors how to identify good investments. For long term investing, companies that know how to innovate and increase demand will have good performance. Likewise, companies that have shown good performance are likely innovators. A long consistent growth is an indicator for good long term investments.
Short term investments are best for companies in a positive disturbance or will be in one soon. What is critical for short term investments is to know when to buy and when to sell. Knowing the period of responses and the lead or lag time will indicate when the low and high points are reached. If the company has no developed plan for creating positive disturbances, when they do reach one they may have a prosperous time but will ultimately have inconsistent growth.
How do stock owners make such decisions? They should base their decisions on factual information. The way information is gained most of the time is through news of some sort. The reporting of factual or opinionated information is news. For a rational stock holder, his opinion to buy, sell or hold is likely based on news[2]. News of current or planned disturbances would have the most significant short term effect. The magnitude of the effect would be in relation to the change in perception. However the actual effect would determine the long term effect since the truth at some point would debunk false perceptions.
Unfortunately, most stock holders by nature of humanity are irrational. Hope and fear influence decisions often in lieu of reason[3]. This method can perpetuate itself in one’s belief in a high stock value can spread to another. But ultimately truth will debunk false perceptions and inflated prices will eventually be evaluated. Hope and fear only directly affect the price of shares and not their value. They can however be a real disturbance causing good companies to close down. The magnitude of the price inflation/deflation would reflect the magnitude of hope or fear.
Conclusion
The significant inputs that affect stock prices are news and perception. This is reasonable since the period of fluctuations of all these are similar. News is reported more and more frequently. Also news changes more frequently. Statistics are more easily compiled and distributed due to computation and internet connections. Fashions and opinions fluctuated more frequently since the world has shrunk. With lightning fast communication, what is hot in one region is adopted by other regions. Stock values behave on hourly basis as well.
With this success is a limitation also. News and perception cannot easily be measured quantitatively. Many attempts are made through surveys are indicators, but with out a standardize way of measuring one press conference from another for goodness of plan; an accurate dynamic analysis cannot be done. The practicality of this papers conclusion is pointing where to look but it cannot answer how these affect stock. With out and accurate description of the input, magnitude and period of response cannot be accurately be predicted. However most all dynamic systems oscillate in periods similar to the forcing inputs.
Another benefit to companies in easily entered fields is the proof that they must develop demand for their product or better ways than other companies in order to earn real profit. How they go about this will determine the period and magnitude of their long term growth.