Discussion 1
The question discusses on the role of the central bank as a financial institution tasked with exclusive rights over supply of money and credit for a country or economic bloc. It is responsible for regulating financial institutions and creating the overall macroeconomic monetary policy. A good number of economist are of the opinion that central banks should burst bubbles in the stock market before they balloon causing damage to the overall economy such as in the burst of the dot com bubble. They believe monetary policy can be used to prick a bubble before they burst.
The central banks can use the Gordon Growth Model (GGM) to determine the true value of a stock pegged on future expected dividends growing at a constant rate. For example, if given a dividend per share payable annually and assuming constant growth in perpetuity, the solution for the intrinsic value is given by the formula:
Where: p is the current price of the stock, g the constant expectation of growth, r constant rate of return, and D1 the value of next year’s dividend (Cecchetti et al, 2001). However, the model can only apply for stable companies that exhibit steady growth in their dividends per share.
Central banks have traditionally used monetary policies to control inflation and as tool to react following the burst of a bubble. However, following successive crises, they have learnt that some costs associated with bursting of a bubble can be difficult to manage. Although, economists who believe monetary policy should be used to brick bubbles are the minority, the central bank can use GCM to find the intrinsic value of stocks to know the interest rate hikes required to burst them. Hence, they can, for example, effectively impose capital surcharges on the trading of some assets. By knowing the intrinsic value of a stock, the central banks can thereby avoid making flawed decisions.
Discussion 2
If I read in the Wall Street Journal that the “Smart Money” expects a fall in price of stocks, I would not act and sell all my stocks because this is information in the public domain. The information will already be reflected in the valuation of stock prices, thus no need to sell (Baker & Ricciardi, 2014). There is no benefit of offloading the shares because the optimal forecasted returns from stock will be equal to the equilibrium return.
Stock price forecasting is the first stage to fundamental analysis and is usually concerned with the historical valuation. But, investors are concerned with future valuation and dividend yield. It is better to utilize forecasting techniques to make investment decisions rather than information available in the public domain. Some of the forecasting techniques an investor can use to make investment decision include: anticipatory surveys and barometric approach. It is vital to carry out industry-wide analysis because ultimately the investor invests in one or more company securities. The information will already have been factored in the valuation of the stock, therefore no need to act on it.
There are indicators the investor can use to peg his or her investment decisions rather than information in the public domain. The indicators include leading indicators such as change in prices, money supply, unemployment rates, and consumer expectations. The investors can also utilize coincidental indicators and lagging indicators to affect their investment decisions. Ultimately, the overall performance of a portfolio will depend on acting on concrete information and diversification.
References
Baker, H. K., & Ricciardi, V. (2014). Investor behavior: The psychology of financial planning and investing.
Cecchetti, S. G., International Center for Monetary and Banking Studies (Geneva), & Centre for Economic Policy Research (Great Britain). (2001). Asset prices and Central Bank policy. Geneva: ICMB.
