University of California Davis Stock Price Fluctuations of a Company Discussion

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I’m working on a economics question and need an explanation and answer to help me learn.

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1. If people know noise traders exist, and have existed for a while, they should understand that the time of solely inferring fundamental value from a firm’s stock price is long past.
Furthermore, they should try and exploit this information as they would any other piece of market news or fundamental analysis. Indeed, it seems like “momentum traders” are already
very much a thing and have been at least since the 1990’s. The momentum investor doesn’t “buy low, sell high”, but “buys high, sells higher”. Now, this strategy wouldn’t necessarily
serve you very well if you were evaluating a non-stock investment in a company, since a momentum strategy really seems like it’s about timing bubbles. For a non-stock investment, the
question you really want to know the answer to, obviously, is whether the company’s value is driven by some underlying appeal which attracts noise traders, or whether it’s value illusory,
being driven by noise traders themselves.
2. I am cynical when it comes to the motivations of CEOs. I am partial to the interpretation that they only care about short-term fluctuations insofar as it affects their compensation, and
that even though the long-term price does say something about the value of the firm, you could see them still only caring because it redounds to their benefit in either case. That a
firm’s stock price affects both the CEO’s compensation and also is an indicator of the firm’s value means that it is difficult to know whether to trust a CEO’s stated motivations or to make
less then generous assumptions about the same.
The first question, I think, is reasonable. Noise traders refer to investors who trade based on noise information unrelated to the basic value, mistakenly believe that they have mastered
the information about the future value of risk assets, and have an overly subjective view on it. If people know that noise traders exist, they will find ways to get more liquidity
information. In addition to fundamental analysis, they will also analyze the information of other financial markets.
Second, the CEO of the company will certainly be concerned about the short-term stock price fluctuation, because the stock price of a company is not only an indicator of the company’s
value, but also affects the CEO’s salary. If the newly appointed CEO is largely due to the poor performance of the previous CEO or the decline of the company’s stock, the new CEO
needs to stabilize and increase the stock price at this time, because they are very concerned.
I think it is rational to look to a company’s stock price as an indicator of how profitable it would be for stakeholders to make a non-stock investment in the company. The reason is
incomplete information. The stakeholders could not identify which part of stock price movement is due to a change in firm value and which part of it is due to the misperception of noise
traders. The stakeholders would rather believe that the upward trend of price is partly due to the rise in firm value and revise upward their non-stock investment in the firm. However, as
the textbook says, it depends on the vagueness of the information. If the information transparency is low, the stakeholders will ascribe more price movement to noise trading. If the
information transparency is high, the stakeholders will ascribe more price movement to change in firm values. If people know that noise traders exist, they will ascribe a larger part of
price volatility to noise trading since, in the short run, the firm’s value is not going to change much. The corporate CEO should not really care about the possibility that short-term stock
fluctuations might have long-term impacts on their companies if the stakeholders do not overact to it. Sometimes, because CEO’s compensation and evaluation depend on the stock price
in the short run. Thus, they will make decisions to try to make the stock price high in expenses of wearing down the fundamentals. This is in their interest in the short run but
aggravating in the long run.
I understand why potential stakeholders would look to a company’s stock price before anything else. It is the most visible attribute of the stock, and it is supposed to represent the
value of allocating capital to that company relative to others. With some companies it would probably be more rational for stakeholders to make their investment decisions solely based
on the stock price. I would guess companies with certain attributes are less susceptible to noise traders than others, but it may be difficult to identify those attributes. Overall, I don’t
think it is that reasonable to invest in a company simply because of the stock price.
I come to this conclusion not solely because of the existence of noise traders. Generally, I think you should choose to invest in companies you have a good qualitative understanding
of. How they operate, who they do business with, and stuff like that. Knowledge of the qualitative in tandem with the quantitative aspects will probably yield better results.
I don’t know if a CEO should care that much about how short – term stock price fluctuations might impact their companies in the long – term. I guess I am not sure how one would
go about effectively combating something like that. Is it a wise decision to hold a bunch of extra cash on hand to repurchase shares every time you believe your stock might be
undervalued? Will that always be the best use of that money? Being concerned about it might actually do more damage to the company over the long – term. As far as the personal
reasons go, it seems reasonable to me that a CEO would care about short – term stock prices if it had a big impact on his own career.

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Explanation & Answer:
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potential stakeholders

stock investment

rational arbitrageurs

simultaneous trades

stock price

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