MODELING THE INTERACTIVE DRIVERS OF THE STOCK MARKET -

A SIMULATION-BASED APPROACH

by

DAVID KAY-YONG GOH

B.A. Econs. (Hons)

York University
(1986)

Submitted to the Sloan School of Management

in Partial Fulfillment of
the Requirements of the Degree of
Master of Science in Management

at the
Massachusetts Institute of Technology
June 1993

© David K. Goh (1993)

ALL RIGHTS RESERVED

Signature of Author
MIT Sloan School of Management
5/8/93

Certified by
John Sterman
Associate Professor
Thesis Supervisor

Accepted by
Jeffrey A. Barks
Associate Dean, Master's and Bachelor's Programs
 MODELING THE INTERACTIVE DRIVERS OF THE STOCK MARKET -
A SIMULATION-BASED APPROACH

by

DAVID K. GOH

Submitted to the Alfred P. Sloan School of Management

on Date, in partial fulfillment
of the requirements of the Degree of
Master of Science in Management

ABSTRACT

Recent mounting evidence contrary to the long held notions of random walk have led to calls
for a "broader analytical framework" to better understand equities securities pricing. This
paper attempts to meet these calls by demonstrating the potential of a simulation-based tool
for synthesizing and testing new and existing theories from a broad spectrum of disciplines.
Based on a cross-disciplinary survey of asset pricing determinants, a system dynamics model
of the S&P 500 Index over the 99 year period from 1889 to 1987 was developed and tested.
The model was then simulated under various theoretical scenarios to draw insight into the
interrelated dynamics of the market and to provide behavioral explanations for the previously
observed phenomena of excess volatility and returns predictability (in the sense of mean
reversion and price-to-dividend returns).

Thesis Supervisor: John Sterman

Title: Associate Professor
 ACKNOWLEDGMENTS

I would like to thank Professor John Sterman for allowing me to pursue my interest in the
equity markets within his Applied System Dynamics course (Fall 1992) and to my surprise
provided me with more support and advice than I had ever hoped. A substantial part of the
model's structure arose from discussion sessions in his office whose door was always open. I
would also like to thank Professor Andrew Lo for being my thesis reader. Thanks also go to
the System Dynamics Thesis Group - Maggie Konner and Jorge Rufat-Latre for their
initiative to start the group, and Kathy Allen, Greg Hennessey, Ann Seligman, and Daniel
Joensen for their mutual support and encouragement.

To Keyna, my precious bride of six years, I owe an unrepayable debt for her loving support,
for keeping me focused on the real things in life whenever I got mired in work, and for
bringing our little Daniel into the world and caring for him so well. To our God and Savior
Jesus Christ who paid the debt He did not owe, we will thank through eternity for the debt we
could not pay.
 TABLE OF CONTENTS
PAGE

ABSTRACT .................................................................................................................................... 2
ACKNOWLEDGMENTS ............................................................................................................... 3
TABLE OF CONTENTS ................................................................................................................ 4
TABLE OF EXHIBITS ................................................................................................................... 6

1. Introduction and Thesis Overview

1.1 Introduction ....................................................................................................................... 8
1.2 Thesis Outline .................................................................................................................... 9

SECTION I - BACKGROUND AND CROSS-DISCIPLINARY SURVEY

2. 60 years of Equities Securities Pricing Theory - The Surprising
Relevance of the Keynes-Graham-Dodds Model
2.1 1930s - The Keynes-Graham-Dodds Model .................................................................... 10
2.2 1930s - 1950s - Random Walk 1 ..................................................................................... 12
2.3 1960s - Random Walk 2 (Efficient Market Hypothesis).................................................. 12
2.4 1970s - Empirical Contradictions to EMH 1 - Anomalies ............................................... 14
2.5 1980s - Empirical Contradictions to EMH 2 -
Volatility, Mean Reversion, Irrational Pricing........................................................................ 16
2.6 1990s - The Noise Traders, Positive Feedback Approach ............................................... 17

3. A Cross-Disciplinary Survey of Asset Pricing Determinants

3.1 Financial Economics ........................................................................................................ 19
3.2 Experimental Economics.................................................................................................. 20
3.3 Evolutionary Economics .................................................................................................. 20
3.4 Historical Economics ....................................................................................................... 21
3.5 Practitioners/Industry ....................................................................................................... 22
3.6 System Dynamics............................................................................................................. 25
3.7 Cognitive Psychology ...................................................................................................... 25
3.8 Social Psychology ............................................................................................................ 27

SECTION II - A SYSTEM DYNAMICS MODEL OF THE STOCK MARKET

4. A Systems Thinking Approach to Understanding the Stock Market
4.1 Fundamental Investors ..................................................................................................... 29
4.2 Speculative Investors........................................................................................................ 30
4.3 Pricing ............................................................................................................................. 32
 4.4 Financial Services Providers ............................................................................................ 33
4.5 Public Issuing Corporations ............................................................................................. 34
4.6 Integrative Causal Loop Diagram .................................................................................... 36

5. Defining the Model: Scope, Variables, Policy Structure

5.1 Scope ................................................................................................................................ 37
5.2 Variables .......................................................................................................................... 37
5.3 Policy Structure................................................................................................................ 39

6. Fleshing out the Model : Structure and Parameterization

6.1 Summary of Model Structure and Parameterization ........................................................ 40
6.2 Brief Explanations of Structure and Parameter Estimates ............................................... 44

SECTION III - TESTING THE MODEL, TESTING THE THEORY

7. Testing the Model: Model Results and Validation Tests
7. 1 Theil Statistics .................................................................................................................. 54
7.2 Spectral Analysis.............................................................................................................. 55
7.3 Comparison with Historical Bounds ................................................................................ 56

8. Testing the Theory: Model Simulations and Insight

8.1 Introduction - Variance Bounds and Irrational Pricing Revisited .................................... 57
8.2 Simulation Scenarios and Results .................................................................................... 57

9. Conclusions
9.1 Conclusion I - Model's Insight into Empirical Evidence ................................................. 61
9.2 Conclusion II - Further Implications/Applications and Future
Development ........................................................................................................................... 62

REFERENCES .............................................................................................................................. 64
APPENDIX A : MODEL iTHINK DIAGRAMS.......................................................................... 73
APPENDIX B : MODEL iTHINK EQUATIONS ....................................................................... 90
APPENDIX C : iTHINK FORMULATION NOTES UNDER THE VARIOUS SCENARIOS
............................................................................................................................................... 112
 LIST OF EXHIBITS

TABLES
1) Performance of the experts ....................................................................................................... 13
2) Summary of Model Structure / Parameterization ..................................................................... 40
3) Regression Results (Prices on Dividends) ............................................................................... 45
4) Sample Asset Allocation Guidelines ......................................................................................... 47
5) Regression of Commissions Revenue on Volume .................................................................... 52
6) Regression of Employees on Commission Revenue ................................................................. 52
7) Simulation Theil Statistics......................................................................................................... 55
8) Asset Classes as a % of the Portfolios of 91 Large Pension Plans, 1974-1983......................... 56
9) Price-to-Value Indicators and Variance Bounds Indicators ...................................................... 59

SIMULATION CHARTS
1) Dividend Discount Model vs.Yardstick (22X Dividend) ......................................................... 46
2) Simulated Price vs Actual S&P500 Price (Deflated) ................................................................ 54
3) Equity Weightings of all investors ............................................................................................ 54

CHARTS
1) % Adult Ownership follows level of S&P 500 Index ............................................................... 50
2) Securities Industry's Profitability driven by level of market commissions .............................. 51
3) # Personnel vs. S&P500 ............................................................................................................ 52
4) Net IPOs vs. Price/Dividend...................................................................................................... 53
5) Spectral analysis: S&P500, Simulated Price, Value (22X Div) ............................................... 55

CAUSAL LOOP DIAGRAMS

1) Fundamental Investor Behavior ............................................................................................... 30
2) Behavior of Speculative Investors (existing and new) ............................................................. 32
3) Price Adjustment Mechanism................................................................................................... 33
4) Securities Industry Dynamics................................................................................................... 34
5) Net IPO Dynamics.................................................................................................................... 35
6) Integrative Causal Loop Diagram............................................................................................. 36

iTHINK DIAGRAMS
1) Fundamental Investor's Equity and Cash Holdings.................................................................. 74
2) Fundamental Investor's Buy/Sell Orders ................................................................................... 75
3) Fundamental Investor's Decision............................................................................................... 76
4) Speculative Investor's Equity and Cash Holdings ..................................................................... 77
5) Speculative Investor's Bull/Sell Orders ..................................................................................... 78
6) Speculative Investor's Decision................................................................................................. 79
7) Pricing Sector ............................................................................................................................ 80
8) Corporate Initial Public Offerings, and Buybacks..................................................................... 81
9) Financial Services Sector Dynamics ......................................................................................... 82
10) Funds Flow and Effect of Word of Mouth and Price Attraction ............................................. 83
11) Trade Fractions........................................................................................................................ 84
12) Total Shares............................................................................................................................. 85
13) Total Equity Weights and Total Cash ..................................................................................... 86
14) Graphs and Tables ................................................................................................................... 87
15) Control Panel for Key Model Variables.................................................................................. 88
1. Introduction and Thesis Overview

".. in all your getting, get insight."1

"..until the right path to truth is miraculously disclosed to us, it will be prudent to explore
along several paths simultaneously."2

1.1 Introduction

The notion of how risky assets are priced has long been a topic of central interest to
philosophers and laymen alike. In the twentieth century this interest has focused on the highly
visible equity securities markets and produced a flood of theories on how equity securities and
their overall markets are priced; in the process a highly respectable field has evolved, and
Nobel prizes have even been awarded. The central thesis of this paper is not to introduce yet
another theory or model, but rather to introduce a tool for synthesizing and testing existing
theories. While it is not the objective of the writer to produce a "model" that explains the
innumerable interrelated factors that drive stock prices, a model is nonetheless built to both 1)
test and validate an "old" theory of equity securities pricing that has recently been retold, and
2) demonstrate the ability of the tool to act as a platform for the incorporation of cross-
disciplinary ideas.

Calls for a "broader analytical framework" to better understand securities pricing are
widespread. LeRoy (1989), Shiller (1989), Arrow (1982), and Summers (1986) are among
those who have voiced the need to break out of traditional molds of theoretical research in
financial economics to incorporate the strong and growing pool of evidence from other
disciplines - particularly the fields of social and cognitive psychology and experimental
economics. At the other end of the "theory vs. evidence" spectrum Smith (1989) calls for
research directed at closing the gap between (investment) decision theory and actual observed
behavior. This writer attempts to meet these calls, and to widen the suggested scope further by
incorporating valuable ideas and evidence from the fields of evolutionary economics,
historical economics, system dynamics, and from investment practitioners.

1.2 Thesis Outline

1 Proverbs 4: 7
2 Simon (1986)
Chapter 2 motivates the remainder of this paper with a historical overview of equity securities
pricing theory since the Crash of 1929 which, interestingly, ends up where it started - with the
Keynes-Graham-Dodds Model of a market composed of heterogeneous investor groups
(particularly speculative investors and enterprise investors by the definition of Keynes
(1936)), incorporating the notions of intrinsic/fundamental value and the presence of irrational
pricing during extreme periods.

The key determinants of asset pricing from various major fields is surveyed in chapter 3 to
provide the supporting material for the simulation model. In section II of the paper, chapter 4
presents a theoretical synthesis of the evidence on security pricing determinants using a
systems thinking approach in mapping the drivers of the stock market, and in chapters 5 and 6
the systems model is defined and fleshed out with structure and parameterization. In chapter 7
the model is validated using a combination of time and frequency domain tests against actual
data (S&P 500 Index over 99 years since 1889), and in chapter 8 the validated model is used
to explain key recent evidence against the random walk / efficient markets hypothesis by
comparing its volatility and price-to-valuation behavior under differing simulation
environments. Chapter 9 concludes the paper and considers the model's implications for
policy.
SECTION I - BACKGROUND AND CROSS-DISCIPLINARY SURVEY

2. 60 years of Equities Securities Pricing Theory - The Surprising Relevance of the

Keynes-Graham-Dodds Model

2.1 1930s - The Keynes-Graham-Dodds Model of Equity Markets

".. we have reached the point where we devote our intelligences to anticipating what
average opinion expects the average opinion to be."
".. most investors' decisions can only be taken as a result of animal spirits - of a
spontaneous urge to action rather than inaction, and not as the outcome of weighted
average of benefits multiplied by quantitative probabilities."
".. all sorts of considerations enter into market valuation which are in no way relevant to
the prospective yield."

While the above observations by Keynes (1936) are most often quoted to illustrate an extreme
view of complete irrationality of speculative markets [Barsky & De Long (1990)], Keynes the
investor was clearly different in action, being highly successful in managing his personal
wealth, and in directing institutional funds as Bursar of King's College, Cambridge; Chairman
of the National Mutual Life Assurance Society (1921-38); Director of Provincial Insurance;
and Director of several investment trusts [Ellis & Vertin (1989)]. In a letter to F. N. Curzon,
Acting Chairman of National Mutual in Keynes' absence who had advocated the sale of
investments in reaction to the market decline of 1937, Keynes wrote, "..I feel no shame at
being found still owning a share when the bottom of the market comes. I do not think it is the
business, far less the duty, of an institutional or any other serious investor to be constantly
considering whether he should cut and run on a falling market.." [Moggridge (1983)].

In a further memorandum for the Estates Committee of King's College [Moggridge (1983)]
Keynes postulated that successful investing depended on three principles, the first of which
being "a careful selection of a few investments (or a few types of investment) having regard
to their cheapness in relation to their probable actual and potential intrinsic value over a
period of years ahead and in relation to alternative investments at the time".

Keynes' model of the market clearly included two groups of investors, the first whom he
refers to as "enterprise" investors, is chiefly interested in the long run intrinsic value of a
stock, and the second whom he refers to as "speculative" investors, concerned only with price
trends and affected by mass psychology.
A similar approach in understanding the market was espoused by Benjamin Graham and
David Dodds (1934), whose principles of fundamental analysis founded an entire industry and
profession, with notable disciples in the likes of Warren Buffet and John Templeton. In
Graham and Dodd's classic Security Analysis (1934) the basis of fundamental investing was
defined as the estimation of "intrinsic value" and its application in "judging whether
securities are over- or underpriced in the marketplace," so that the analyst will not be "a
potential victim of the tides of pessimism and euphoria which sweep the security markets"
and will not be influenced by "the fads and herd instincts of major participants in the
marketplace."

Early efforts to estimate the intrinsic value of stocks focused on discounting the future
expected stream of dividends to the present as first discussed byWilliams (1937) and later
developed by Gordon (1957) into the dividend discount model:
D
Valu e =
r−g
where D = current dividends
r = required rate of return
g = projected long term growth rate of dividends

In summary, under the Keynes-Graham-Dodds Model, the prices of securities and hence the
overall market is determined by two main groups of interacting factors. Price is determined by
investors' trading in stocks which in turn is determined by i) the level of appraised value
relative to current price for fundamental investors, and ii) the trend or projected direction of
prices for speculative investors.
2.2 1930s - 1950s - Random Walk 1

Beginning in the 1930s, empirical studies that focused on the statistical properties of
commodities and financial assets were undertaken3. In (1934) Working published a study on
the statistical properties of wheat prices and found the changes to be basically random in
nature. In an exhaustive study of the behavior of weekly U.K. stock prices and U.S.
commodity prices, Kendall (1953) convincingly concluded the series possessed the statistical
properties of randomness. Further and more sophisticated econometric work by Granger and
Morgenstern (1963) provided further support for the foundational notions of the Random
Walk and Efficient Market Hypothesis.

The empirical evidence for the random walk has its theoretical roots in a French Phd
candidate named Louis Bachelier who in 1900 looked at the prices of bond prices on the
Paris Bourse and described in his dissertation [Bachelier (1900) in Cootner (1964)] the
random motion of speculative prices in a formulation that later provided the foundation for
options pricing theory.

Other studies during this period focused on the ability of market forecasters [Roberts (1959)]
and brokerage analysts [Cowles (1933)] to outperform the market. Both types of studies
showed clear evidence that the majority of technical and fundamental investors had no
predictive power.

2.3 1960s - Random Walk 2 (Efficient Market Hypothesis)

As noted by Blume and Siegel (1992), whilst the formulation for a random walk in security
prices was first outlined by Bachelier (1900), it wasn't until the 1960s that the theoretical
framework for the random walk was developed by Samuelson (1965), Mandelbrot (1966) and
Fama (1965).

In its simplest form the principal theory (following from the martingale and fair game
definitions) proposed under the random walk hypothesis was that:
E(p t+1φt ) = p t

3 Blume and Siege (1992) notes that these tests which were aimed at estimating the degree of
dependence among successive price changes and hence the random nature of security prices
fell under two major types. One was correlation tests, and the other was runs tests. The runs
tests counted the number of runs of positve changes, of zero price changes, and of negative
price changes and compared these numbers to those expected under the random walk
hypothesis.
where pt = price of security at time t,
φt = information set available at time t

The early theory of unpredictability of security returns generated empirical studies on two
fronts: 1) the ability of mutual funds to outperform the market [Sharpe (1966), Jensen (1968),
and Friend, Blume, and Crockett (1970)] and 2) speed of adjustment of market prices to new
information [Fama, Fisher, Jensen, and Roll (1969), Scholes (1972)].4

In his seminal (1970) paper Fama surveyed the empirical literature on the unpredictability of
security returns and brought the term 'efficient capital markets' into general use. Fama defined
three levels of efficiency (i. strong, ii. semi-strong, and iii. weak) based on the interpretation
of the information set φ ( i. containing past prices and returns alone, ii. containing all public
information, and iii. containing private as well as public information). Early studies on
technical analysis were applied to prove weak form efficiency and the above studies on
mutual fund performance and price adjustment to new information demonstrated semi-strong
efficiency.5

Fama's (1970) survey has been noted to have marked a high point for capital market
efficiency [LeRoy (1989)] with most of the evidence accumulated since contradictory rather
than supportive.6 Subsequent research has been formed along two chronological lines as
outlined in the following two sections.

4 On the whole the ability of the professional fund management industry to match a passive buy-and-
hold strategy has continued to be dismal as shown below:

Table 1 : Performance of the Experts

Time Period S&P 500 Returns Equity Funds Returns Differences
(SEI Universe)
1962 - 1974 5.3 4.1 -1.2
1966 - 1974 2.1 0.4 -1.7
1970 - 1974 2.2 -0.3 -2.5
1975 - 1982 14.7 13.4 -1.3
1983 22.3 20.3 -2.0
1984 6.3 -2.0 -8.3
1985 31.7 30.0 -1.7
1986 18.3 16.7 -1.6
1987 5.2 4.0 -1.2
Source: SEI Funds Evaluation, Wood (1989)

5 While Fama did not seek to demonstrate strong form efficiency, studies disproving strong
form efficiency have been performed. Jaffe (1974) found that insiders (based on insider
trading reports filed with the SEC) profited by about 6% in returns more than non-insiders.

6 Fama himself has been a key figure in questioning the notion of efficiency and rationality of
market pricing and the implications for the asset pricing model of Sharpe (1964), Lintner
(1965), and Black (1972) [Fama & French (1988, 89, 92)]
2.4 1970s - Empirical Contradictions to EMH 1 - Anomalies

Beginning in the late 1960's, a steady stream of anomalies were uncovered regarding the
predictability of stock returns with regard to various factors (calendar factors, valuation
measures, etc.).7

A summary of the major findings is briefly described below:8

Size
An early study by Ball and Brown (1968) noted the anomalous difference in price adjustment
to new information for small stocks, with prices still reacting for several days after a large
earnings surprise, with the phenomenon termed "post-earnings-announcement drift." Later
studies by Blume and Friend (1974) showed that there were substantial differences in the
returns between large and small firms that could not be explained by the Capital Asset Pricing
Model (which in turn assumes market efficiency).

Calendar Anomalies
Connected to the size effect were findings that the stock returns for smaller companies were
significantly greater in January than in other months [Rozeff and Kinney (1976)], and further
identification of a seasonality in returns [Officer (1975)].9 Other calendar anomalies focused
on the "day-of-the-week effect", with Monday returns (i.e. from Friday close to Monday
close) being on average negative [Cross (1973)].

Closed-end Investment Companies

Blume and Siegel (1992) notes the persistent puzzle of closed-end investment companies
which almost always trade at significant discounts to their underlying net asset values (over
the past 30 years the discount on the seven largest funds has averaged about 15% and, in the
mid-1970s, has been as high as nearly 30% [Blume and Siegel (1992), see also Lee, Shleifer
and Thaler (1990)].

7 Proponents of efficient markets have always minimized such evidence however, citing the
argument that a clear selection bias problem exists [Merton (1987)].

8 For a comprehensive survey of the various anomalies and a unified framework for
disentangling and analyzing the various return effects, see Jacobs and Levy (1988).

9For more recent evidence on and size and January effect see Banz (1981), Basu (1983), and
Keim (1983, 86).
P/E
Beginning with Nicholson's (1968) article presenting evidence that stocks with low price-
earnings ratios systematically outperform those with high price-earnings ratios, a flood of
other valuation type anomalies began to be researched (Basu (1977), Reinganum (1981) on
price-earnings, Rosenberg, Reid and Lanstein (1985) on price-to-book value as a predictor,
and most recently in an exhaustive cross-sectional study by Fama and French (1992)).

Value Line
Black (1973) presented empirical evidence that the security recommendations of Value Line
Investment Survey, which reviews and ranks over 1,700 common stocks, had significant
value. From April 16, 1965 through December 30, 1990, stocks in Value Line's top rated
group saw annual compound gains of 14.1% while stocks in their bottom rated group saw
annual compound losses of 0.6%.

Wednesday Effect
Fama and French's (1986) more recent work focused on the period in 1968 when the NYSE
was closed on Wednesdays in order to ease the paperwork backlog at brokerage houses. Their
finding that volatility in prices from Tuesday to Thursday was lower than over other two-day
intervals suggested that it was the trading process itself rather than just fundamentals that
generated further and greater trading and price changes.

Volume
Corollary to the "Wednesday Effect" finding, LeRoy (1989) notes that the volume of trade in
equity markets and high turnover of funds (sometime up to 100%) is itself indication that
trading is motivated by much more than fundamental information alone, and in fact the
majority of trades appear to reflect "belief on the part of each investor that he can outwit other
investors", which is inconsistent with common knowledge of rationality.

2.5 1980s - Empirical Contradictions to EMH 2 - Volatility, Mean Reversion, Irrational

Pricing

A further and more rigorous group of theoretical challenges to the long held notion of
unpredictability of returns and rational asset pricing began in the late 1970's, focusing on
excess volatility, returns predictability, and irrational pricing:

i. Excess Volatility
Shiller (1979, 1981) and LeRoy and Porter (1981) were the first to argue that the same
theoretical models which imply that returns on equity securities should be unforecastable
should also imply that the prices of those securities should have volatilities that are lower
relative to their underlying dividends.

Volatility tests under these "variance-bounds" theorems showed that the volatilities of equity
market prices were in fact considerably higher than their underlying dividend-based "intrinsic
value". Shiller rejected the random walk model of efficient markets in favor of the existence
of elements of irrationality in securities pricing, while LeRoy and Porter more conservatively
noted the results as anomalies. Shortly after publication of the original studies it became clear
that aspects of the original tests were subject to serious econometric problems. Flavin (1983)
pointed out a small-sample bias problem while Kleidon (1986) and Marsh and Merton (1986)
were among the first to question the use of standard statistical tests to analyze long-term
series (dividends) that tend to behave like random walks (i.e. violating the assumption of
stationarity). A new round of "variance-bounds" tests which took into account the biases that
were pointed out however, showed the same results [these have been surveyed by West
(1988)].

ii. Returns Predictability

Under the random walk hypothesis, there would be no tendency for stock returns to revert to
some statistical mean. A number of studies however demonstrated that there was a tendency
for stock returns to revert to some average value over long periods [Poterba and Summers
(1988)]. Using variance ratios to test for mean reversion (where the variance ratio is defined
as the variance of k-period returns divided by the variance of one-period returns multiplied
over the k periods), Poterba and Summers (1988) showed that the variance ratios declined
with k, indicating the presence of a mean-reverting component. Lo and MacKinlay (1988)
found that weekly and monthly stock returns had positive autocorrelation coefficients on the
order of 30 percent allowing them to reject the random walk hypothesis.

On a different tack, De Bondt and Thaler (1985, 87) showed that stocks that were extreme
winners or losers over the previous 3 to 5 year periodtend to reverse their behavior in
subsequent years.

iii. Irrational Pricing

Parallel to studies on the ability of past returns to predict future returns, attention also focused
on the ability of fundamental indicators like price-to-earnings ratios and dividend yields to
predict returns. Taking the lead from the price-to-earnings anomalies discovered in earlier
studies, Fama and French (1988a) found that between 25% and 40% of the returns on equities
over long periods could be attributable to the dividend yield.
In their (1992) paper, Fama and French performed an extensive cross-sectional study of stock
returns using both size and another fundamental valuation measure (price-to-book value) as
predictor. In their results they argued that "although 'price-to-book value' has long been touted
as a measure of the return prospects of stocks, there is no evidence that its explanatory power
deteriorates over time" adding further that "if stock prices are irrational, the likely persistence
of the results is more suspect".

2.6 1990s - Noise Traders, Positive Feedback

As the evidence of the 70's and 80's mounted, financial economists began to look for
alternative theories to explain the stock market in a way which could incorporate the
empirical contradictions to efficient markets. The search led to renewed interest in the
possibility of heterogeneous investor groups, with one group that is rational and trade on
information and another group that is irrational and trade on noise. While Black's (1986)
terminology of "noise traders" has been taken up by this new group of theories, its conceptual
origin clearly goes further back, to the original Keynes-Graham-Dodds Model outlined
earlier. Also preceding the recent interest in heterogeneous groups of investors was an
insightful article written by an academic/practitioner [Bagehot (1971)] wherein three types of
investors were described: i. transactors possessing special information, ii. liquidity motivated
transactors who possess no special information but are simply seeking to convert securities
into cash or vice versa, and iii. transactors acting on information which they believe has not
yet been fully discounted in the market price, but which in fact has (noise traders).

Shleifer and Summers (1990) posited an alternative to the efficient markets approach which
rests on two assumptions: "First, some investors are not fully rational and their demand for
risky assets is affected by their beliefs or sentiments that are not fully justified by fundamental
news. Second, arbitrage - defined as trading by fully rational investors not subject to such
sentiment - is risky and therefore limited." Shleifer and Summers argue convincingly that the
ability of the rational investors ("arbitrageurs") is limited by two key risks - the first being
fundamental, wherein their perception of value may be wrong, and the second being the
unpredictability of future prices since the existence of noise traders makes arbitrage
opportunities highly risky (i.e. what is overpriced relative to underlying value may become
even more overpriced, turning a short sale position into a loss).

Shleifer and Summers define the behavior of noise traders by pointing out that "one of the
strongest tendencies documented in both experimental and survey evidence is the tendency to
extrapolate or to chase the trend." Lakonoshok, Shleifer and Vishny (1991) provide empirical
evidence pointing to the herding (i.e. buying or selling the same stocks as others) and
positive-feedback trading (i.e. buying winners and selling losers) behavior of institutional
investors.
3. A Cross-Disciplinary Survey of Asset Pricing Determinants

Two conclusions can be drawn from the previous chapter. First, that the Keynes-Graham-
Dodds Model of the stock market is still very much relevant today, despite a half-century
detour into the random walk and its mathematics; second, given that there exists a group of
investors whose behavior is subject to sentiments and non-fundamental information, it would
be necessary to look outside traditional financial economics (with its assumptions of full
rationality) in order to better understand the cognitive, sociological and institutional factors
that drive equity market prices.

This chapter presents a brief survey across various disciplines in an effort to better understand
the key determinants of asset prices. The evidence provided here will then be integrated in the
following section of the paper in the conceptualization and development (structure and
parameterization) of a simulation model of the market.

Key determinants of asset prices as seen by the various disciplines follow:

3.1 Financial Economics

i. Heterogeneous investor groups with 2 key differing investment behaviors

There is a "noise" trading group which tends to trade on trend extrapolations (buy on
uptrends, sell on downtrends), and an "arbitrageur" investor group that trades on
perceived fundamental value (determined by some function of dividends or earnings - e.g.
by use of the Gordon dividend discount model or some valuation yardstick). The actions
of the arbitrageurs is limited by the risk that prices may move further away from their
perceived value due to strength of speculative demand and/or error in fundamental value
perception (this behavior is clearly non-linear - that is, the further prices drift from
perceived value, the more aggressive the fundamental investor will be in seeking arbitrage
profits).

3.2 Experimental Economics

i. Price Trend Trading & Judgmental Extrapolation

As noted earlier, the trend of price movements have been shown in experimental settings
to be a strong enough determinant to encourage trading. People trade more because prices
are moving up or down, and the direction of the price trend determines the direction of
their trades (buy in up markets, sell in down markets). Andreassen and Kraus (1990)
found through analyses of experimental results (trading patterns, profit data, and memory
 measures) that "subjects were more likely to sell as prices fell and to buy as prices rose"
and that "people often forecast using cognitive procedures that resemble formal time-
series extrapolation models".

Smith, Suchanek and Williams (1988) studied spot asset trading in an environment in
which all investors receive the same dividend from a known probability distribution (thus
eliminating the uncertainty of fundamental value). They report that in fourteen of twenty-
two experiments price bubbles nonetheless evolved, and that with experience, the
incidence and extent of bubbles declined but was never totally eliminated. Smith and
Williams (1992) further reports that subjects clearly knew what fundamental value was,
but in many cases traded against their fundamental strategy in hope of getting more
favorable prices.10

3.3 Evolutionary Economics

i. Importance of mutually reinforcing trend following (or technical) rules.

Arthur (1992) reports results of an experiment at the Santa Fe Institute with 100
computerized agents each using 60 predictors. The agents were able to generate new
predictors themselves based on the institute researchers' genetic algorithm [Arthur
(1990)]. Arthur found that "after some time, mutually reinforcing trend following or
technical-analysis-like rules began to appear in the predictor population", with initial
appearance like those of simple extrapolative predictors.

3.4 Historical Economics

i. Role of financial service institutions in bull/bear markets

Strong markets provide incentive for new investment service institutions to exploit the
public's increased desire to invest. Galbraith (1954) notes that while before 1921 there
existed only about 40 investment trusts in the U.S., with the bull run of the subsequent
years, by 1927 there were already 160 trusts in existence and a further 140 were formed
that year. In 1928 a further 186 trusts were organized, and by the early months of 1929,
approximately one new trust was introduced each business day with a total of 265
introduced that year11. Capital raised by these trusts grew from $400 million for 1927, to

10 One subject said that while his strategy was to buy below dividend value and sell above,
when the market moved above dividend value he "bought anyway in hope that it would rise
higher"; another said that "when the market turned down, I knew I had blown it, not selling
earlier, but I just couldn't bring myself to sell even though prices were still above dividend
value".
11 See also Carosso (1970)
 a staggering $3,000 million raised in 1929. White (1990) also noted that the number of
wholly-owned securities affiliates of commercial banks grew from 10 in 1922 to 114 in
1931, and these institutions "attracted many new customers and became big distributors
of stocks and bonds."

ii. Deterioration of investor and investment professionals' sophistication during bull markets
With the rapid expansion came both investors and investment "professionals" that were
less sophisticated and highly susceptible to "bubble" conditions [Neal (1990)]. White
(1990a) notes that the "overall sophistication of investors was weakened by the influx of
new people into the market." In a special study of the investment industry commissioned
by the Securities Exchange Commission in 1961 in response to the bull market of the late
1950's, it was found that "almost 28% of the 210 firms registering with the Commission
during the first quarter of 1961 included no experienced persons among their principals,
and over 50% of the firms were in the hands of persons with under two years' experience,
although some had been security analysts, traders, or office managers" [Hazard and
Christie (1964)]. The SEC Study also found that 95% of the salesmen hired by large firms
specializing in mutual funds had no securities experience.

iii. Role of fundamentals in initiating historical "bubbles"

White (1990a) noted that "from 1922 to 1927 dividends and prices moved together, but
while dividends continued to grow rather smoothly in 1928 and 1929, stock prices soared
far above them," and while investors "bid up stock prices based on an extrapolation of
few years' earnings growth," "managers did not increase dividends as quickly." His
conclusion is that while a change in fundamentals may have initiated the boom,
fundamentals clearly did not sustain it. Mill (1848) provided a much earlier observation
of this phenomenon by noting that "a rise in price for which there were originally some
rational grounds, is often heightened by merely speculative purchases, until it greatly
exceeds what the original grounds will justify." Mill added that "after a time this begins to
be perceived; the price ceases to rise, and the holders, thinking it time to realize their
gains, are anxious to sell. Then the price begins to decline: the holders rush into the
market to avoid a still greater loss, and, few being willing to buy in a falling market, the
price falls much more suddenly than it rose."

iv. Diffusion Effects in the Investing Population

As the market continues a sustained bull run, the rise in prices and profit opportunities
creates a diffusion in investment interest, with a greater proportion of the country's
population participating. Shiller (1989) points out that during the strong market years of
the 1950's and 1960's, the New York Stock Exchange shareownership surveys showed
 that the total number of individual shareowners as a percent of the U.S. population rose
from 4% in 1952 to 7% in 1959 and to a peak of 15% in 1970; as a result of the inflation-
ravaged market of the 1970's, participation rate fell to 11%. An often quoted instance of
the extent of this diffusion of investment interest during the 1920's bull run is an article
that found its way into the Ladies Home Journal in 1929 entitled "Everybody Ought to Be
Rich" in which Crowther (1929) promoted as "the greatest vision of Wall Street's greatest
mind," an idea by General Motors senior finance executive John Raskobto create a
"trust" enabling an ordinary investor to put up $200 in cash, borrow $300 from a finance
subsidiary, and buy $500 in stock.

3.5 Practitioners/Industry

i. Use of Price/Dividend Ratio as yardstick

Goh (1991) in his survey of fundamental market analysis tools used by successful
practitioners notes the effectiveness of valuation measures (price-to-earnings, price-to-
dividends, price-to-cash flow, or price-to-book value) in indicating market excesses.
Carter and Auken (1990) surveyed the techniques used by investment managers from four
major financial sectors (investment banking, bank trust departments, investment
managers, and insurance). In all three key areas of fundamental securities analysis (at the
firm, industry and market levels), price to earnings (or its alternative price to dividends)
ratios were the highest-ranked or second ranked technique. Bernstein (1983) in his
specification of the appropriate valuation parameter for the equity component of asset
allocation emphasizes the "superior quality" of the information embodied in dividends,
and its usefulness as a proxy for economy-wide performance (the technique first
suggested by Graham and Dodds (1934)).

Two examples of the use of price-to-dividend ratio as an indicator of an over or under-

valued market are Michaelis [in Train (1989)] and Lynch (1993). In his 1987 report to
shareholders of the highly successful closed-end fund Source Capital, George Michaelis
warned that "in the last five years stock prices have risen from 1.1X to 2.5X book value,
from 8X to 25X trailing earnings, and dividend yields have declined from over 6% to
only 2.3%, a revaluation from record historical lows to record breaking highs," adding
that "however accustomed to it we all have become, this revaluation cannot be a
sustainable source of continuing future returns (for Source Capital)." Lynch's use of
dividend yields were in conjunction with long bond yields where his "signal" for an
overvalued market was when long-term bond yields exceed dividend yields by more than
6%.
ii. Price arbitraging behavior of fundamental investors
Soros (1987) noted that the key to success was not to counter the irrational wave of
enthusiasm with immediate selling, but to ride this wave awhile and sell out later. Train
(1987) in his survey on the investment techniques of "money masters" noted the common
use of this technique and called it "pumping up the tulips".

iii. Role of financial service institutions and industry hiring dynamics

Rosenberg (1987) noted the "feedback loop" nature of the financial services industry's
connection to the market, where a strong market will present investment advisors with an
attractive recent track record which is used to solicit more funds for investment. The
funds flowing in in turn creates in the shorter term increased demand for stock and
support for prices. Babson (1973) in lamenting the consistent inability of investment
experts to beat the market notes that one of the key problems of the industry at the time
was the lack of appropriately "aged" and experienced expertise, which as a result of low
hiring during the 1930's through the 1950's and massive hiring during the 60's in response
to strong markets, led to the industry having excessive rookies, with two-thirds of
professional fund managers in their 20's and 30's only.

iv. Public Issuing Corporations' response to market levels

Ellis (1971) notes that "during and after major declines in the common stock market, such
as occurred in 1969-1970, corporations will repurchase stock because the current market
price is less than the perceived long-term value (emphasis original) of the common
shares." The reverse is certainly true, with Ritter (1991) pointing out that the reason IPOs
perform badly is because firms time their offerings so that most go public during periods
when the entire market is selling at high market-to-book ratios.

v. Lowering of valuation "standards" in response to market runs

Graham and Dodds (1934) pointed out that the "new vogue of financing through common
stock offerings" in 1928 and 1929 as a result of the strong market led to the lowering of
fundamental standards of valuation by investment banks (which in turn promoted
overvalued issues strongly). Le Baron (1976) noted that "as the pace of the market
quickened from the mid sixties, the time required to thoroughly research, document and
distribute detailed information proved inadequate for performance-hungry institutions"
and as a result brief summaries of recommendations would be disseminated before
thorough reports were prepared, creating a "greater fool" trap wherein institutional
investors with full discretionary powers "would move on sketchy advance warning
knowing that a report was to come" and that "success would appear later in the form of a
 more detailed report that would spark buying pressure from the slower-moving
institutional investors (those having less discretionary power)".

vi. Faddist behavior of institutional investors

Le Baron (1976) further noted that "institutional investors tend to be faddists. They are
very concerned with what will be bought or sold by other institutions in the next year or
two, and they are more interested in practising successfully the "greater fool" theory than
in making fundamental determinations of value. After all, values may be undiscovered for
a long time, whereas the discovery of an industry itself can bring quick profits."

3.6 System Dynamics

i. Adaptive expectations and trend extrapolation

Sterman (1987) demonstrated through the test of a behavioral model of trend expectation
formation against actual forecasts (in short-term expectations of inflation and long-term
expectations of energy demand) that adaptive expectations and trend extrapolation were
used in the expectation formation processes of forecasters. Sterman also identified
additional judgmental heuristics (anchoring and conservatism) that systematically biased
the forecasts.

ii. Misperception of feedback in dynamic decision making

A key finding of the field of system dynamics is that complex systems are
counterintuitive and that people perform poorly in decision making as a result of limited
cognitive skills and the inability to perceive feedback structures [Forrester (1961),
Sterman (1989a, 1989b)].

3.7 Cognitive Psychology

i. Bounded Rationality
Central to cognitive psychology's contributions in determining the key factors that affect
asset prices is the notion of "bounded rationality" pioneered by Simon (1955, 56) in his
study of decision making and choice. Simon's argument was that humans lack both the
knowledge and computational skills necessary to make decisions in a manner compatible
with economic notions of rational behavior. In Simon's view, whereas human decision
making is not rational from an economic standpoint, it is still purposeful. Simon's goal
was therefore to describe "reasonable" as opposed to "rational" behavior. Applied to the
framework of security prices, investors may be expected to act according to what they
 perceive is most reasonable in their judgment, although given their information
processing limitations their decisions may not be deemed fully "rational" or optimal.

ii. Information Acquisition and Processing Biases

Hogarth and Makridakis (1981) in their survey of the ability of forecasters and planners to
process information sets out two key findings from cognitive psychology relating to
human judgment: (1) the ability to process information is limited [from Simon (1955,56)]
and (2) people are adaptive. As a result of people's need to understand and control the
environment they live in despite their cognitive limitations, systematic biases develop in
their acquisition and processing of information. Some of the biases surveyed include the
following:12

In their acquisition of information, people are subject to the biases of a) availability -

where the frequency of well-publicized events are over-estimated (e.g. media focus on
strong market days may lead to false perception of sure profits) [Tversky and Kahneman
(1973)]; b) selective perception - where people tend to seek information consistent with
their own views and hypotheses (e.g. people with large existing positions in markets are
slower to respond to changes in price-to-valuation) [Wason (1960)]; c) illusionary
correlation - described in the false pattern recognition example below.

In their processing of information the biases surveyed are: a) conservatism - being the
failure to revise opinions on receipt of new information [Edwards (1968)]; b) non-linear
extrapolation - being the inability to extrapolate exponential growth processes (e.g.
investors are often surprised at their inability to recognize a "bubble" at the time when
presented with historical charts showing exponential price growth) [Cohen, Chesnick and
Haran (1971)]; c) anchoring and adjustment - where forecasts of future growth is made
by adjusting last year's growth [Tversky (1974)]; and d) "rules of thumb" - heuristics used
to reduce mental effort particularly in professions where there is need to make decisions
under significant uncertainty.

iii. Behavior under uncertainty

Three categories of systematic "irrationality" on the part of economic agents in their
behavior under uncertainty were surveyed by Arrow (1983) 13:
i) Miscalculation of Probabilities - Arrow cites Tversky and Kahneman (1974) to show
that individuals are overly influenced by current data and put too little weight to prior

12 An insightful collection of works in the area of judgment under uncertainty is found in

Kahneman, Slovic and Tversky (1982)
13 See also Machina (1987)
 information. Arrow points out that since the value of long-lived assets like bonds and
equities are ultimately dependent upon a great many events which will occur in the future,
it should be unresponsive to any particular piece of new information. The opposite is
instead observed; ii) Preference Reversal - where the work of Lichtenstein and Slovic
(1971) was cited as evidence that people are irrational and reverse their preferences in
their choice between two gambles when a dollar amount is involved (a case of this in
investment is the tendency for investors to try to average their cost and stay "locked" in a
hopelessly declining stock even though they would not consider buying it if they had not
already owned it); iii) Framing - where Tversky and Kahneman's (1981) work showed
that the decisions people made were influenced by the way the questions were phrased or
"framed".

iv. False pattern recognition and the persistence of trend trading

Arthur (1992) illustrated the tendencies of pattern recognition, hypothesis formation, and
inductive behavior through Feldman's (1962) cognitive experiments wherein subjects
were asked to predict which of two events (the appearance of a "1" or "0") would occur
next in a sequence of 200 trials. Feldman found that each subject was quick to spot
patterns in the sequence of 1's and 0's and to form hypotheses on the process generating
the sequence even though the true sequence of 1's and 0's used by Feldman was random.
Trend trading persists for this reason, that people are consistently convinced that
profitable patterns (or trends) can be read.

3.8 Social Psychology

i. Contagion effects, Social Comparison effects

Klausner (1984) notes that in composition and behavior, market participants constitute
what in sociology is termed a "mass", and as such they are subject to the dynamics of
contagion theory, including interstimulation, suggestibility and "circular reaction" (or
positive feedback reaction). Klausner further notes the findings of Rose (1951) that during
periods of hyperemotional arousal people are more vulnerable to rumors and suggestions
and are very likely to act on the basis of them. Social comparison theory maintains that
humans have a relentless need to evaluate their opinions, beliefs and abilities on the basis
of others. Blotnick (1980) observed from a survey of market participants that "investors'
judgment of what is sensible is based on how well a friend did.". Asch (1951) notes that
the majority of a group can unduly influence the judgment of minority members (this
resulting tendency towards "groupthink" is particularly strong in the spatial and
communicative concentration of Wall Street).
ii. Heterogeneity of professional investment orientations
Based on a participant observation study, in-depth interviews and the aid of a key
informant, Smith (1981) found four classes of professional investor orientations: 1) the
fundamentalist (or economic orientation), 2) the insider (or influence-based orientation),
3) the cyclist (or chartist orientation), and 4) the trader (or market action orientation).
SECTION II - A SYSTEM DYNAMICS MODEL OF THE STOCK MARKET

The following section (chapters 4, 5, and 6) presents a system dynamics model of the stock
market. The approach taken in building the model is as follows: 1) First a synthesis of the
previous chapter's cross-disciplinary evidence on the factors that drive stock market
investment behavior is presented using the system dynamics tool of causal loop diagramming,
2) Second, the causal loop representation of the mental model is formalized through a policy
structure diagram, with the model scope and variables for use in constructing the model using
iThink simulation software defined, 3) Finally, the relationships within the simulation model
are parametized.

4. Mapping the Feedback Structure of the Stock Market

Following from the evidence of the previous section, the basic mental model or theory that the
system dynamics model is attempting to represent is that the general price level of the market
(measured by some index) has four key components - prices follow not only the underlying
intrinsic value of the composite companies, but is secondly influenced by both speculative
investor behavior, the marketing efforts of the securities industry, and the stock issuance/buy-
back behavior of public corporations. A sector-by-sector approach to understanding the stock
market follows:

4.1 Fundamental (Information) Investors

It should be noted at the outset that it is not predefined as to who is a fundamental investor
and who is a speculator. In general most people exhibit a mix of both types of behavior
[Shiller (1989), Smith and Williams (1992)]. A given person may follow fundamental roles at
certain times and speculative roles at others, as market trends change [Andreassen (1990)].
The description of investors that follow below should then be interpreted as types of behavior
rather than types of people.

The classical fundamental investor uses a strategy based on an estimate of "long-run"

investment value in relation of current price and on an estimate of the chance for capital gains
and losses [Soros (1987), Shleifer and Summers (1990)] . Such investors try to buy when
prices are well below investment value, entering the market when the chance of a capital gain
appears to be high (i.e. when price/value ratio nears their perceived bottoming levels); they try
to sell when prices are above their estimated investment value, accelerating their sell orders as
the price/value ratio approaches their fundamentally perceived topping value [Day & Huang
(1990)] (balancing loops B1 & B2). These are the investors described by Keynes as “serious
minded individuals who purchase investments on the best long-term expectations they can
frame” [Keynes (1936)], and termed by Fisher Black as “information traders” (as contrasted
to “noise traders”) [Black (1986)]. Constraining their ability to "arbitrage" on the market is
their level of non-equity wealth.

Causal Loop Diagram 1: Fundamental Investor Behavior

Equity
Fundamental - +
Holdings
perception of +
topping Sell Orders
price/value ratio
Fundamental (-)
perception of B2 Non-equity
bottoming Wealth
price/value ratio -
+
Buy Orders -
-
+
Price/Value
(-) Buy/Sell Ratio
Ratio
B1
+
- +
Price
+ Chng in Price
Fundamental perception
of market value

4.2 Speculative (Noise) Investors

The speculative investment subsystem has two principal components, the behavior of present
investors in responding to the price level of the market (via judgmental extrapolation), and the
behavior of "would be" investors in response to both word-of-mouth and self-observation of
potential for speculative gain. The principal psychological dynamics driving theses investors
are described below:

a. Judgmental extrapolation and trend expectations (R1 & R2)

It has been proven that people may often forecast using cognitive procedures that resemble
formal times-series extrapolation models, such as exponential smoothing [Andreassen &
Kraus (1990), Sterman (1987,1988), Arthur (1992), Shleifer and Summers (1990)].

Such behavior is not restricted to the non-professional investor as previous studies have
shown that the "forecasts" of professionals/experts exhibit consistent patterns of error similar
to those generated by a myopic process of adaptive expectations [Sterman (1987)]. In a post
1987-crash survey [Shiller (1987)], one-third of institutional and individual investors said that
the price dropping below a 200-day moving average was a key influence in their decision to
sell.

b. Price change attraction (reinforcing loop R4)

People are attracted by observed price changes. Observed past price increases means
observing other people becoming wealthy who invested heavily in the market, and this
attracts more participants into the market [Shiller (1989)].

c. Word-of-mouth, diffusion effect (R3 )

Corollary to price change attraction, positive feedback to drive demand for stocks can come
through direct interpersonal communication. Research in social psychology has shown that
direct interpersonal communications among peers is of great importance in promoting attitude
change [Wheeler (1966), Adler (1984)].

In a survey, respondents, both individuals and investment professionals, report that their
interpersonal communications influenced them and appeared to influence others. For most
individual and most institutional investors in stocks undergoing rapid price increase, initial
attention to particular investments is not the outcome of systematic research, but the result of
prompting by others [Shiller (1987)]. The spatial and communicative concentration of
investment professionals further heightens this effect, [Adler (1984)].
 Causal Loop Diagram 2: Behavior of Speculative Investors (existing & new)
+ +
Recent Price Excess Demand
Price for stock
+ - (Buy orders less
(+) sell orders)
Rising Falling
R1
Price Price
Trend Trend Anticipated +
+ +
+ Future Price -

(+) Loss
R2 Non-equity
Anticipated
Wealth
Future Price
+
Gain

(+)
+ R3
Word-of-mouth
+ Total
Attraction
(+) Attraction
+ R4 + to Invest
Observational
Attraction

4.3 Pricing Sector

The pricing subsystem models the behavior of prices in response to buy/sell activity.
Although the model does not explicitly include a market maker, the response of prices to
demand/supply is in line with the function of the specialist or market maker. The role of the
market maker is to mediate transactions on the market by setting the price in response to
excess demand or supply, and at this price supply excess demand from inventory or
accumulates inventory when there is excess supply. His primary role is to mediate
transactions out of equilibrium, that is, to ‘make the market’ when demand exceeds supply or
vice versa [Stoll (1985)]14.

Clearly the ‘specialist’ would not want to be accumulating inventory in a period of sustained
selling nor be running down inventory when there is clearly sustained excess demand [Ho and
Macris (1986)]. The adjustment mechanism is thus price, and to clear the market the bid price
raised when there is excess demand (hence buy transactions are at higher prices) and the ask
price lowered when there is excess supply (hence sell transactions are at lower prices) (B3).

Causal Loop Diagram 3: Price Adjustment Mechanism

14 See also Ney (1974) for a more critical practitioner's view.

 -
Buy/Sell
Ratio

Price (-)
B3
+
+
Price Ch

4.4 Financial Services Providers

The co-existence of boom and bust in the stockbroking/investment industry is usually taken as
a necessary resulting influence of the stock market on which it is dependent. There are
however vital connections between the stockbroking industry and the stock market as one
feeds the other. Two principal dynamics of the sector are described below:

Commissions-Marketing Effect on Funds Flow

When the market performs well, the volume and value of aggregate transactions go up,
creating a "boom" demand scenario for the stockbroking/investment industry. Investment
professionals sell their services to less knowledgeable new investors based on past total
performance, stepping up their marketing efforts. To the extent they are successful, new
investors and additional funds are added to the demand for stocks [Galbraith (1954), White
(1990)] (reinforcing loop R5). This aggregated demand may further enhance performance,
and hence produce yet another positive feedback loop [Rosenberg (1987)].

Industry Employment and Research Quality

With the increase in business volume, there is increased need for staff both to market services,
and to provide research support [White (1990a), Neal (1990)]. Shepard (1975) provided
empirical evidence showing staff count to be a key non-price competitive variable for the
securities brokerage industry, driven by the volume and value of trade. With the obvious lag
in training and competence, research quality is compromised. As the fundamental value of
stocks takes second place to the marketability of stocks, [Babson (1973), Graham and Dodds
(1934), Le Baron (1976)], the aggregate market’s perception of fundamental value stretches
(i.e. perceived topping price/value ratios increase) further justifying the rising trend in prices
(R6).

Causal Loop Diagram 4: Securities Industry Dynamics

 Fundame -
percepti
toppi
price/valu
Volu
- (+ Activ
R +
Sell
+
Commiss
Fee
Qualit
- Exce fundame
Demand resear
+
-
(+
R
+
+
Market Ne
+ Effo I d

4.5 Public Corporations

Net IPOs are defined as initial public offerings and other rights issues by new and existing
public listed companies, less the rate of share buyback/corporate acquisition activity. The
higher prices are, the higher the price-to-value ratio (whether measured by price/earnings or
price/book value or some other ratio), and hence the more attractive it becomes to issue stock
(at low earnings yields, this would be much more attractive than borrowing) [Ellis (1971),
Ritter (1991)]. Increasing the supply of shares however would naturally lead to a reduction in
the excess demand for stock and in turn will lead to lower prices, creating a balancing loop
(B3).
Causal Loop Diagram 5: Net IPO Dynamics

Price
+
+

Price/Value Excess
Ratio Demand for stock
(-)
B3 -

+ Net IPOs
4.6 Integrative Causal loop diagram

Fundamental -
perception of
topping -
+ Equity
price/value ratio Holdings
+
Sell Orders (+)
R6
(-) Volume/
Fundamental Activity
B2 Non-equity
perception of
bottoming
Wealth +
price/value ratio - +
+
Buy Orders - Commissions/
- Fees Quality of
+
Price/Value fundamental
(-) Excess
Ratio research
B1 Demand for stock
+
- -
- + - +
Fundamental +
Perception Price +
of Value +
+ - (+)
(+) New
Rising Falling R5 Marketing
R1 Industry
Price Price Efforts
Trend Trend Hires
Anticipated +
+ Future Price
(+) Loss
R2 Anticipated
Future Price
+
Gain
(-)
B3
+ Net IPOs
+ (+)
R3 Total
Word-of-mouth + +
Attraction
Attraction
to Invest
+ (+) +
R4
Observational
Attraction
5. Defining the Model: Scope, Variables, Policy Structure

5.1 Model Scope

The model simulates the annual price behavior of the S&P500 Index over the 99 year period
from 1889 through 1987. The model is driven by the following key variables, all being
endogenous except two - actual dividends based on the S&P500 Index (from 1889 through
1987), and actual consumption (from 1889 through 1987), both adjusted for inflation. A
listing of key variables (or variable groups) follow:

5.2 Key Variables (or Variable Groups)

Fundamental and Speculative Investors' Sectors
1. Equity holdings of fundamental and speculative investor (# shares, $ cost, and $ mkt value)
2. Non-equity holdings of fundamental and speculative investor ($)
3. Actual and desired equity holdings of both fundamental and speculative investors ($ value)
4. Trend of Previous Prices (% change)
5. Anticipated future price ($)
6. Fundamental perception of value ($)
7. Fundamental perception of topping and bottoming price/value ratio (dimensionless)
8. Buy orders by fundamental and speculative investors (shares/year)
9. Sell orders by fundamental and speculative investors (shares/year)
Exogenous: 10. Historical Deflated Dividends of S&P500 Index (yearly from 1889 through
1987)
Securities Industry Sector
11. Securities industry commissions ($/period)
12. Securities industry marketing effort ($/period)
13. Securities industry hiring/firing (# of persons/period)
14. Rookie analysts (#)
15. Seasoned analysts (#)
16. Quality of research (dimensionless)
Public Corporations Sector
17. Net Corporate IPOs/Buybacks (# of shares/period and $/period)
18. Price-to-Value Ratio (dimensionless)
Flow of funds Sector
19. Effect of Price Observation/WOM on funds flow (dimensionless)
20. Effect of Securities industry marketing on funds flow (dimensionless)
Exogenous: 21. Historical Deflated Consumption as proxy for base rate of funds injection
(index)
Pricing Sector
22. Price ($)
23. Total Buy/Sell Orders (# of shares/year)
24. Effect of Buy/Sell on Price (dimensionless)
5.3 Policy Structure
The five key subsystems of the model are represented below:
Research Information

Investors'
Cash &
Shares
Information/ Noise/
Investors'
Fundamental Speculative
Cash &
Investors Shares Investors
Subsystem Subsystem

Price/volume
Information
Price/volume
Information
Demand
for
Demand Excess Stock
Net for Demand/
IPOs Stock Market Makers
Proceeds Pricing
Subsytem Mktg
Net Effort
IPOs
Price/volume
Information
Price/volume
Information Commissions/
Net Fees
IPOs

Financial
Public Net Services
Corporations IPOs Providers
Subsystem Proceeds Subsystem

Commissions/
Fees
6. Fleshing out the Model : Structure and Parameterization

6.1 Summary of Model Structure / Parameterization

In the development of the model, parameterization of relationships took one of three
approaches: 1) when actual historical data was observable and available, regressions were
performed to obtain relational estimates (for example, the number of employees in the
securities industry is regressed on the overall level of the market and the estimates used in the
model), 2) when actual data was not available or the phenomenon not directly observable, and
when the relationship was of a non-linear nature, judgmentally specified functions were used
(an example is the effect that price-to-value has on fundamental investors' decision on equity
asset allocation), and 3) when actual data was not available but direct assumptions based on
industry knowledge could be used, these were approximated accordingly (for example, it is
assumed that it takes rookie analysts three years to develop into seasoned analysts).

Table 2: Summary of Model Structure / Parameterization

Sector Structure / Parameter Discipline / Source
Overall 1. Heterogeneous Investors Financial Economics
Model (arbitrageurs/fundamental Keynes (1936)
investors vs. noise Bagehot (1971)
traders/speculative investors) Black (1986)
Shleifer & Summers (1990)
Social Psychologists
Smith (1981)
Practitioners
Graham-Dodds (1934)
2. % Mix Between Fundamental and Financial Economics
Speculative Investors Poterba & Summer (1988)
3. Financial Services Industry Historical Ecnomics
White (1990)
Practitioners
Rosenberg (1987)
Le Baron (1976)
4. Funds Flow / Net IPOs Financial Economics
Ritter (1991)
Practitioner
Fisher (1930)
Historical Economics
White (1990)
Arbitrageurs/ 1. Price/Dividend as indicator for Financial Economics
Fundamental fundamental value Ball (1978)
Investors Shiller (1989)
Campbell & Shiller (1988)
Fama & French (1988b, 92)
Practitioners
Dow (1920)
Graham-Dodds (1934)
Williams (1937)
Train (1989)
Lynch (1993)
Goh (1991)
2. Curvature and limits of asset Financial Economics
allocation decision rule (based on • Arbitrageurs' Behavior
price/dividend ratio) Poterba & Summer (1990)
• Mean Reversion in Price/Value
% Shiller (1989), Regression Results
Eqty • Price/Value Extremes
Hlg Black (1986)
Cognitive Psychology
• Decision Making Under
Uncertainty
Hogarth (1981)
Practitioner
• Asset Allocation
Price/Value
Ibbotson & Brinson (1987)
Noise Traders/ 1. Price Forecasting and Speculative Financial Economics
Speculative Behavior • Positive-Feedback Trading
Investors Lakonishok, Shleifer and Vishny
% (1991)
Eqty Experimental Economics
Hlg • Adaptive Price Forecast Behavior -
Smith, Suchanek, and Williams
(1988)
System Dynamics
• Expectation Formation -
Sterman (1987)
Forecast Price/ Cognitive Psychology
Price • False Pattern Recognition -
Feldman (1959)
• Extrapolative Judgment -
Andreassen (1987, 8)
Evolutionary Economics
• Evolved Ecology of Extrapolative
Decision Rules
Arthur (1992)
Practitioners
• Trend Investing -
Edwards and McGee (1954)
Flow of Funds 1. Price change attraction to invest, Historical Economics
contagion model Galbraith (1954)
White (1990)
Cognitive Psychology
Wheeler (1966)
Social Psychology
Adler (1984)
Financial 1. Industry growth's impact on Historical Economics
Services Industry investing community White (1984, 1990)
Galbraith (1954)
Practitioners
Rosenberg (1987)
Le Baron (1976)
Graham and Dodds (1934)
Public 1. Issuing corporations' response to Practitioners
Issuers/ overall market's price/value level Ellis (1965)
Corporate Ritter (1991)
Behavior

Price Sector 1. Price response to excess buy/sell Economics

orders Stoll (1985)
Ho and Macris (1986)
% Practitioners
Price
Ney (1974)
Chng

Net Buy
Orders
6.2 Brief Explanations of the Parameterization of Sectors
Fundamental Investors
i. Proxies for Value
As noted by Hogarth and Makridakis (1981) people tend to use rules of thumb to help them
decide under uncertainty. In the investment management profession, price-to-dividend ratio
(or the inverse of dividend yield) is commonly used as a yardstick [as discussed in chapter
3.5.i. above] with the boundaries about 2.3% and 9.0% (about 44X and 11X price-to-
dividend). The mean of the range (being 22X or about 4.5%) is used as a proxy for value.
Two tests of the appropriateness of this rule-of-thumb approach were undertaken. In the first,
Shiller's (1989) regression results were replicated to show that over the long-term, price-to-
dividend ratio shows mean reversion about the 24X level, and in the second the
appropriateness of the 22X ratio was tested against the dividend discount model of Gordon
(1956) using the iThink simulation program to model the expectational variable of future
dividend growth.

Shiller's (1989) description of the relationship between real price and real dividend through a
distributed lag regression of price on dividend was replicated. This is an attempt to estimate
the mean price-to-dividend ratio that the market reverts to over the long term (and the
"investment yardstick" used by practitioners). Distributed lags based on second-degree thirty-
year polynomial with far endpoint tied to zero were used throughout by Shiller. My results are
based on twenty-nine-year polynomials, due to the lack of an extra year of data.

The regression results (See Table 3) show that when the real price is regressed with a twenty-
nine-year distributed lag on current and lagged real dividends, the current real dividend has a
coefficient greater than the average price-dividend ratio, and the sum of the coefficients of
lagged real dividends is negative. The sum of all coefficients of real dividends, both current
and lagged, is about the average price-dividend ratio over the entire period (about 23 times).
This implies that prices tend to be unusually high when real dividends are high relative to a
weighted average of real dividends over the past thirty years and low when dividends are low
relative to this weighted average. Over the long term price-to-dividend ratio of the market
displays mean reversion about the 22-23 times level.
Table 3: Distributed lag regressions for real stock prices or returns on real dividends, selected
periods, 1900-1983 a

Sample Statistics
Sum of
Coefficient Coefficient F-stat
of Current s of lagged Coeffi. (Signi R^2
Sample Depende Independe independen of .. Stan. (D. W
Period nt Constant nt Variable t variable c lagged level Error stat)
Variable error of F)
b

Independent Variable is Real Dividends d

1900-1983 Price -0.09 34.74 -10.97 _ 251.4 0.07 0.90

(-3.21) (14.09) (-3.98) (0.00) (0.80)

1900-1983 Price -0.08 28.05 -4.89 0.67 312.5 0.06 0.94

with (-1.14) (8.22) (-0.95) (7.07) 1 (1.87)
AR(1) (0.00)
1900-1982 Return 0.09 -7.30 10.03 _ 2.80 0.19 0.10
(t+1) (1.23) (-1.12) (1.34) (0.05) (2.05)

1926-1982 Return 0.17 -8.26 5.64 _ 1.51 0.21 0.08

(t+1) (1.38) (-1.00) (0.60) (0.22) (2.05)

a. Numbers in parentheses under the coefficients are t-statistics. Distributed lags based on
second-degree thirty-year polynomial with far endpoint tied to zero were used throughout
by Shiller. My results shown here are based on twenty-nine-year polynomials, due to the
lack of an extra year of data. The stock price used throughout is the Standard and Poor's
composite price index.
b. Dependent variable Price is the stock price index for January divided by the January
producer price index. Dependent variable Return(t+1) is the real return from January of the
following year to January of two years hence (deflated by the producer price index) based
on the stock price index and Standard and Poor's composite dividend series.
c. The sums are for the twenty-eight lagged values and do not include the coefficient of the
current independent variable, which is shown separately.
d. Standard and Poor's dividends per share adjusted to the stock price index, total for four
quarters, divided by the January producer price index.

The use of 22 times price-to-dividend ratio to represent the investment practitioners' yardstick
for value was tested using a second method of estimating intrinsic value - being the use of
Gordon's (1956) dividend discount model15. As recalled from above, the model is:

15 Zeikel (1980) cites the use of Gordon's dividend discount model by major securities firms
in analysing the market.
 D
Valu e =
r−g
where D = current dividends
r = required rate of return
g = projected long term growth rate of dividends

Of the three variables in the model, dividend is most readily available. We next assume that
the required rate of return is the rate that prevailed at the beginning of the data set (i.e. in
1871).16 For the value of g (projected long term growth rate of dividends), a system
dynamics formulation of long term projections was used, wherein g is dynamically estimated
by adaptive extrapolation. The results of the simulation is encouraging as it shows that the
dividend discount model's estimation of value over the period is fairly similar result of using
the heuristic of estimating value through some yardstick figure (estimated at 22 times). The
result is shown graphically below:

16 In a more representative model the required rate of return should itself be modeled
dynamically based on investors' expectations for future long-term interest rates. The impact
of the bond market on equity asset allocation would in that formulation be also taken into
account . For the purposes of this model interest rates are assumed to be constant.
 Simulation Chart 1: Dividend Discount Model vs. Yardstick (22X Dividend)
1: DivX22 2: DivDisValue
39.32

21.57

2 2
3.81
1889.00 1913.50 1938.00 1962.50 1987.00
Years

ii. Asset Allocation Behavior

In parameterizing the effect of price-to-value ratio on buy/sell orders, a non-linear table
function was used. This process of adjusting equity weights according to price-to-value
estimates is in line with the practice of investment professionals:

Table 4: Sample Asset Allocation Guidelines

Policy Norm Current Strategy

Strategy Ranges
Common Stocks 55% X 30% - 80%
Fixed Income 25% X 10% - 40%
Cash Management 0% X 0% - 45%
Real Est. Equity 15% X 12% - 18%
Venture Capital 5% X 3% - 6%
100% 100%
Source: First Chicago Advisors, from Ibbotson&Brinson(1987)
 Fundamental Investor Equity Investment Decision

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0

1
0.2

0.4

0.6

0.8

1.2
-1
-1.2

-0.8

-0.6

-0.4

-0.2

1.44 * Log (Price-to-Value Ratio)

Speculative Investors
i. Trend Extrapolation and Asset Allocation Decision (existing investors)
In line with the articles cited above, the response of speculative investors to historical price
trends is modeled by a non-linear function with the future anticipated price gain plotted
against the % of equity allocation decision.

Speculative Investor Equity Investment Decision

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1
0.75

1.04

1.08

1.12

1.17

1.21

1.25
0.792

0.833

0.875

0.917

0.958

Forecast Price / Price

ii. Price Attraction Effects

The word-of-mouth and observational attraction effects were aggregated, and modeled by a
non-linear table function with anticipated price gain driving the multiplicative factor effect on
the rate of new funds flowing into the market. This mental model of a contagion or diffusion
effect of the overall market on the investing population is verified by the following chart
(with significant regression results showing relation between S&P500 Index and % of Adult
Population owning shares - we should note however that part of the overall rise in adult
ownership is due to structural and institutional factors such as the increase in company
employee stock option plans, etc.).
 Chart 1: % Adult Ownership follows level of S&P500 Index

%Adult Ownership vs. S&P500

0.25 160
140
0.2
120
100
0.15
80
0.1 &
60
S&P500
40
0.05
Frac Own Shrs 20

0 0

1952 1956 1959 1962 1965 1970 1975 1980 1981 1983

Regression: R^2=0.76, T-Stat=5.00

Source: NYSE Fact Book (Various years)

Price Setting Sector
i. Effect of Buy-to-Sell Ratio on Price Change
The effect of buy-to-sell ratio has on price change (current price is a stock that accumulates
that change) is modeled by a non-linear function.
 Buy/Sell Effect on

0.6

0.5
0.4
0.3
0.2
0.1
0

-
0.2
0.3
Total Buy Orders /

Financial Services Providers

i. Effect of Market Level on Commissions and Employment, Effect of Employment on
Quality of Research
Following the approach of Shepard (1975), both the effect of the overall level of the market
on commissions and employment level were estimated by regression of historical data, where:
Commission Revenue = a * Price * Volume of Trade, and
Personnel = b + c* (Commission Revenue)

The level of commission revenue was then translated into marketing and effect on new
attraction to invest, and the number of personnel was translated into the quality of
fundamental research and effect on perception of topping price/value ratio, by table functions.
The historical relationship between commissions and employment in the securities industry
and the market are shown graphically below:

Chart 2: Stockbroking Industry's Revenue Driven by Value of Trade

 Stockbroking Industry Revenue vs. Market

200 140
180 120
160
140 100
120 800
100 600
80
60 400
40 200
20
0 0
Table 5: Regression of Commissions Revenue on Volume

Regression Statistics :
Commissions ($ mln) vs. Volume ($ mln)
R Square 0.57
Adjusted R 0.49
Square
Coefficients Standard Error t Statistic
Volume 0.0078834 0.0006172 12.773

Chart 3: Securities Industry's Hiring in line with Commission Revenue

Commissions vs. Industry Employment

14000 90000
80000
12000
70000
10000
60000
8000 50000

6000 40000
30000
4000
20000
2000 10000
0 0

Table 6: Regression of Employees on Commission Revenue

Regression Statistics :
Employees vs. Commissions
R Square 0.93
Adjusted R 0.93
Square
Coefficients Standard Error t Statistic
Intercept 20805.08 3328.21 6.25
Commissions 6.0735 0.4750 12.7859

Public Issuing Corporations

The number of net new shares introduced into the market is estimated by regression, and the
cost of the new shares is assumed to be at the price of the overall market.

Chart 4: Net New Initial Public Offerings Related to Price/Dividend Ratio

 Net IPOs vs Price/Div
35 180

30 160
140
25
120
20 100
15 80
IPOs - Repos
60
10 (#m)
40
5
Price/Div 20
0 0

1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964

Regression: R^2=.44, T-Stat=2.67

Source: Ellis (1965)

SECTION III - TESTING THE MODEL, TESTING THE THEORY

In chapter 7 the model is validated using a combination of time and frequency domain tests
against actual data (S&P 500 Index over 99 years since 1889), and by comparison with the
market's actual asset allocation and price-to-value history. In chapter 8 the validated model is
then used to explain recent evidence against the random walk / efficient markets hypothesis
by comparing its volatility and price-to-valuation behavior under differing simulation
environments.

7. Testing the Model: Model Results and Validation Tests

Simulation Chart 2: Simulated Price vs. Actual S&P500 Price (deflated)

1: Price 2: S&PDfl 3: DivX21
49.36

1
1
1
27.14
3
2
1
1

4.93
1889.00 1913.50 1938.00 1962.50 1987.00
Years

The graphical results for the period 1889 through 1987 show the model's simulated price
exhibiting similar characteristics of bull/bear cycles over the 99 year time span.

7.1 Theil Statistics

The table below shows statistical results from the test of fit. The R2 for the model is 54%.
The Theil statistics which partitions the Mean Squared Error into its contributing 3
components show the bulk of the MSE (88%) is due to point-to-point fit (i.e. covariation)
with the contribution to MSE due to bias (trend) of 0% and due to variation (volatility) of
12%.

Table 7: Simulation Theil Statistics

Simulated Price vs. Actual S&P500 Index (deflated) 1889 through 1988
R2 RMSE MSE Bias Variation Co- MAPE
variation
Simul.
vs. Actual 0.54 7.12 50.67 0.00 0.12 0.88 0.15

7.2 Spectral Analysis

The results of spectral analysis of the model against the actual S&P500 index is shown
graphically below.

Chart 5: Spectral Analysis of S&P500, Simulated Price, and 22X Dividend

SPECTRAL ANALYSIS: BASE, SP500, 22XDIV

0.16 BASE
0.14
SP500
0.12
0.1 VALUE

0.08
0.06
0.04
0.02
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14
CYCLES PER 99 YEARS
7.3 Comparison with Historical Bounds

Simulation Chart 3: Equity Weighting of All Investors

1: TEqtyToW
0.67

0.53

0.40
1889.00 1913.50 1938.00 1962.50 1987.00
Years

The total equity weight of the two groups of investors of our model (fundamental and
speculative) reflects actual historical weights (see below) although the historical upper
boundary of 86.5% is higher than the boundary generated by the model (about 70%). It should
be noted that the model captures the entire investing community (private and institutional
funds) while the table below reflects only institutional funds.

Table 8: Asset Classes as a % of the Portfolios of 91 Large Pension Plans

for period 1974 through 1983

Asset Classes Average Minimum Maximum Standard

Deviation
Stocks 57.5% 32.3% 86.5% 10.9%
Bonds 21.4% 0% 43.0% 9.0%
Cash 12.4% 1.8% 33.1% 5.0%
Other 8.6% 0% 53.5% 8.3%

Source: SEI Corp. Large Plan Universe, from Ibbotson and Brinson (1987)
8. Testing the Theory: Model Simulations and Insights

8.1 Introduction - Variance Bounds and Irrational Pricing Revisited

In Shiller's original formulation, the efficient markets model is described by asserting that pt =
Et(p*t), i.e., pt is the mathematical expectation conditional on all information available at
time t of p*t (theoretical value of market); or, pt is the optimal forecast of p*t. Defining the
forecast error as ut = p*t - pt, and since under optimal forecasts the error must be uncorrelated
with the forecast, it follows that var (p*) = var (u) + var (p), and hence the variance bound is
set as var(p)<=var(p*).

Shiller argues that there are elements of irrationality in the market that results in the reverse
(i.e. that var(p) > var(p*)) whilst under our expanded cross-disciplinary framework the
reasons for the excess volatility are modeled as the presense of speculative investors (existing
and new) and self-reinforcing dynamics of the financial services industry. We test this
expanded framework model by computing Shiller's variance bounds to see if volatility can be
reduced by removing the speculative and financial services sectors from our model, and in
turn run Shiller's bounds test to see if his result holds under a non-speculative scenario.17

The simulations also seek to explain and test the irrational pricing hypothesis by observing
the simulated price-to-value bounds under various scenarios. Our hypothesis is that if the
majority of market participants were "rational" in the sense of trading only on fundamentals
(even on the basis of simple fundamental yardsticks), the price-to-value bounds (which
proxies the valuation premium from dividend yield or price-to-book value that Fama (1992)
pointed out) should be reduced.

8.2 Simulation Scenarios and Results

The model is simulated under the following scenarios:
A) Assumes No-Leakage Between Fundamental and Speculative Investors
1) 100% Fundamental - assumes that the market comprises 100% of investors who make asset
allocation decisions strictly on fundamental grounds (i.e. the speculative investor sector of the
model is "switched off" with all new funds flowing into fundamental investor sector).

17 It is noted that Shiller's original variance bounds tests were subject to econometric
problems which were subsequently addressed. In our simple tests we are more concerned
with the relative comparison of the variance bounds under different scenarios than with their
exact magnitude.
2) 80% Speculative - assumes that the market comprises 80% of investors who make asset
allocation decisions solely on the expected future prices (using extrapolative expectations)
with 100% of all new funds flowing into the speculative sector of the model.

B) Assumes Leakage Between Fundamental and Speculative Investors

3) 50% Wealth Turnover - assumes that 50% of total wealth (cash and equity assets) of both
groups of investors are turned over each period.

4) 100% Wealth Turnover - assumes that 50% of total wealth (cash and equity assets) of both
groups of investors are turned over each period.

5) No Financial Services Sector - assumes that there are no interrelated dynamics between
the financial services sector and the market (i.e. industry's boom and bust does not affect
funds flow or quality of research).

6) Fixed Fraction of New Funds to Speculative/Fundamental Investors - assumes no diffusion

effect (i.e. during extended bull runs the proportion of new funds entering the market between
speculative and fundamental orientation remains constant).

7) No Corporate IPOs Dynamics - assumes that a constant percentage of new shares enter the
market each year (i.e. net IPOs are not affected by price-to-valuation levels).
The results of the simulations are shown in table 9:18
Table 9: Price-to-Value Indicators and Variance Bounds Indicators
Price-to-Value Variance
Bounds

Base Conditions Average Max Min Max/ Variance Variance Var(P)/

Min (Price) (Value) Var(V)

Base Model
(22X Div as proxy
for value) 1.23 1.92 0.75 2.56 67.34 31.42 2.14

Alternative
Model
(DDM as Value) 1.24 1.92 0.76 2.53 62.03 31.42 1.97

S&P 500 (Actual) 1.18 2.01 0.56 3.56 101.45 31.42 3.23

Simulation Scenarios

A) Non-Leakage (No Wealth Transfer between Fundamental/Speculative )

1) 100% are 1.01 1.52 0.65 2.34 15.27 31.42 0.49
Fundamental
2) 80% are 0.83 3.89 0.05 77.80 131.87 31.42 4.20
Speculative

B) Leakage (Wealth Transfer between Fundamental/Speculative Investors)

3) 50% Wealth 1.29 3.32 0.52 6.38 133.44 31.42 4.25
Turnover
4) 100% Wealth 1.20 3.83 0.32 11.97 146.86 31.42 4.67
Turnover
5) No Financial 0.95 1.42 0.68 2.09 42.9 31.42 1.37
Services Sector
6) Fixed Frac.
New Funds to
Speculative 1.07 1.60 0.69 2.32 24.65 31.42 0.78
7) Constant 1.26 2.11 0.76 2.78 72.01 31.42 2.29
Net IPO

1) Under all the scenarios, the model still manages to "track" its theoretical value with the
average price-to-value ratio keeping between 0.80 to 1.30. This is true even for the 80%

18 For details of iThink simulation settings under the various scenarios see Appendix C.
speculative scenario because the wealth of the 20% fundamentally oriented population
eventually rises to match the speculators' and influence the market - under this scenario a
huge bubble is generated in the early part of the simulation which as a result of its collapse
erases most of the speculators' wealth advantage as they sell on the downtrend even as price
falls to only 0.05 times value!

2) 100% Fundamental and 80% Speculative scenarios- the variance bounds results under
these two extreme scenarios indicate the significant impact of speculative investors on market
volatility with var(p)/var(p*), (where p* = 22X div), falling to 0.49 under the 100%
fundamental scenario and rising to 4.20 under the 80% speculative scenario (compare with
2.14 under the base case and 3.23 under the actual S&P500). The ratio of 0.49 under the case
of no speculative investors is consistent with Shiller's variance bounds theorem that
var(p)<=var(p*). The difference between rational and irrational pricing under the two extreme
scenarios is equally marked, with the max/min of the price-to-value ratio at 77.80 under the
80% speculative scenarior versus 2.34 under the 100% fundamental scenario (which
compares with 3.6 times for the actual S&P500 Index and 2.56 times under the base scenario
with 50/50 fundamental/speculative mix).

3) 50% Wealth Turnover - under this scenario where 50% of wealth of both groups of
investors are turned over each period, the effect of fundamental investors' change in strategy
(to speculative trend investing) results in a more volatile market (variance bounds ratio jumps
to 4.25 from 2.14 under the base case where only 4% of wealth gets turned over each year).

4) 100% Wealth Turnover - under this scenario, the volatility of the market rises further to a
variance bounds ratio of 4.67 and the ratio of maximum to minimum price-to-value ratio
jumps to 11.97 from 2.56 under the base case.

5) No Financial Services Sector scenario - the results confirm the hypothesized importance of
the financial services industry in contributing to the bull/bear cycles of the market. Variance
ratios fall to 1.37 when the sector is "switched off" (vs. 3.23 for the actual S&P500 and 2.14
for the base model), and price-to-value boundaries narrow to a max/min ratio of 2.09.

6) Fixed Fraction of New Funds to Speculative/Fundamental Investors - variance ratio falls

to 0.78 under the scenario of no diffusion effects, with the max/min of price-to-value falling
to 2.32.

7) No Corporate IPOs Dynamics - the balancing role of public corporations in their net IPOs
behavior (by issuing more stocks when the market is high and buying back more when the
market valuations are low) is demonstrated by the increase in variance ratios (from 2.14 under
base case to 2.29 under constant net IPOs), and increase in incidence of "irrational pricing"
(with max/min ratio of price-to-value increasing to 2.78 from 2.56 under the base case).

9. Conclusions

9.1 Conclusion I - Model's Insight into Empirical Evidence

Overall the model helped the builder gain insight into the recent empirical evidence
contradicting the random walk / efficient markets hypothesis. A brief discussion of each of
the three key contradictions follow:

1) Excessive Volatility
The excess volatility observed in historical stock prices (e.g. Shiller’s work using variance
bounds test) is replicated in our model, and is primarily due to a definitive behavioral pattern
of speculatively oriented investors who tend to chase prices in up markets and sell off markets
in down markets, and speculatively oriented non-investors who are drawn into the market by
rising prices. Speculation interacts with fundamentally oriented investors to yield a dynamic
bull/bear phenomenon. This excessive volatility is further exacerbated by the co-existence of
the securities industry whose marketing efforts are linked to the level of the market and in
turn affect the rate of the flow of new funds into the market, and whose boom/bust hiring
patterns create periods of low quality research during bull markets. Mitigating these excessive
effects is the rate of supply of new stock through net initial public offerings.

2) Irrational Pricing
Irrationality is clearly demonstrated on the part of the speculative investors whose strategy is
over the long term dominated by the strategy of the fundamental investor. The argument that
investors must in the long term be rational because the irrational would be dominated by the
rational and hence driven out of the market through loss of capital is found to be weak in our
model when the effect of fresh funds flowing into the market in response to price or word-of-
mouth attraction is considered (these may be through new participants or fundamentally
oriented investors’ wealth that has been transferred to speculatively oriented investors as in
the case of inheritance or good/poor fund management strategies). Under these circumstances
it is arguable that the value-related anomalies (low P/E, low Price/Book Value premium) will
not go away, but rather continue to persist [Fama (1992)].

3) Mean Reversion, Autocorrelation

The market is strongly mean-reverting over the long term and on the basis of its price-to-
value ratio. The bounds of 2.0 times and 0.50 times price-to-value have been set historically,
and near those limits the probability of a down market is clearly much higher than the
probability of an up market. Past price performance hence has a significant impact on the
probability of direction of future prices.

9.2 Conclusion II - Further Implications/Applications, and Future Development

1) Usefulness of key indicators for market analysis

The model demonstrates, particularly through highlighting the bounds in price-to-value ratios,
the usefulness of key indicators for market analysis [Goh (1991)]. While good systems of
indicators have been developed and have gained wide recognition (two key research houses
that systematically maintain such indicators in the U.S. are Shearson Lehman’s Sector
Analysis Unit, and the Montreal-based research publisher Bank Credit Analyst),
organizational-wide learning of these indicators, and the accompanying understanding of the
dynamics of flow of funds and securities industry’s dynamics is probably still much in
lacking in the securities industry.

2) Importance of understanding securities industry dynamics, funds flow and diffusion

effects
Corollary to the above, the model demonstrates the importance of understanding and
observing securities industry dynamics in assessing the state of the overall market. The role of
the flow of funds into the market and the effects of the diffusion of investment interest is
clearly an important factor in assessing the market and the social dynamics of the investment
industry cannot be ignored.

3) Areas of future development - i) The model may be made richer by capturing a wider
representation of the various techniques of fundamental and technically-oriented investing
behavior). ii) A microworld to familiarize users with the various possible market analysis
indicators, and to develop insight into the principal investing behaviors, and the dynamics of
the securities industry may be developed. The microworld may be developed to allow the
user’s asset allocation decisions to affect the overall market to some extent.
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