Equity Markets

  • Most watched, most emotional and least reflective of economic conditions because they price sentiment of company’s future earnings into the valuation1
  • Fundamental analysis takes a discounted cash flow approach to the valuation of a stock by viewing a stock as a series of future earnings and discounting those by a risk-adjusted rate.
  • A relative valuation of a stock is based on the value of other similar stocks on some type of metric for example Price to earnings ratio
  • There is the idea of a Central bank “put” where the Central Bank will backstop equity markets. Currently, the Federal Reserve is not allowed to purchase equities, but there are other ways it may help stock prices.
  • Private equity
  • Hedging by options dealers and sudden equity drops

Passive income in equity markets

  • Passive investment is money flowing into the stock market on a regular basis through employee participation in retirement plans. This inflow is insensitive to valuation metrics and so as it becomes more popular it changes the dynamics of the market:
    • The market trends higher because there is a steady inflow
    • The rich get richer because stocks with higher market caps are indexed by popular funds which is where passive money tends to flow. This in turn increases the price of these large cap stocks
    • It makes value investing harder because “cheap” smaller companies are not likely to see the influx of passive

References

1.
Wang, J. J. Central Banking 101. (Joseph, 2021).

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