A market is a place for people to come together to exchange things, be it widgets, corn, government bonds, or shares of a company. Here I will be focusing on the exchange of stocks which make up the equity stake (assets – liabilities) of a public company. Anyone is able to participate in the ownership of stock in any publicly traded company. Public companies break their equity down into discrete parts, called shares. Each share represents a percentage of the total equity. For example, if a company has 100 shares, each share constitutes 1% of the equity. The interesting part is what determines the price of a share. This can get very tricky and dozens if not hundreds of variables are involved. But to simplify, the price reflects both the past history of the company, the current tangible worth of a company, and speculation on the company’s future. Let’s solidify this with some examples.
Example: Apple (AAPL)
Apple is the most valuable publicly traded company in the world with a market cap of $710 Billion dollars (all data from July 11, 2015). Market Cap is the sum dollar value of all shares at the current market price. Apple has approximately 5.76 billion shares each valued at $123.28 giving us the $710 Billion dollar valuation. Each share consists just 0.000000000174% of the equity of Apple. So how is such a tiny bit of the company worth so much money? Each share of Apple represents an earnings of $8.09. How do we get from $8.09 in earnings per share to current price $123.8? This mainly comes down to future speculation and is measured in the Price to Earnings Ratio or PE. The PE ratio is calculated by taking the current share price divided by the earnings per share to give a ratio of earnings per share.
Current Share Price/Earnings per share = PE Ratio
$123.28 per share/$8.09 earnings per share = 15.24
Historically the PE of most companies is around 15 and we can see AAPL is close to that. That means people are willing to pay $15.24 for every $1 of net profit Apple generated (based on the past 12 months of performance also called trailing twelve month, TTM). There is also a prospective PE ratio (usually called the Forward PE) that uses estimates of future performance for the next 12 months. The PE ratio is one way to interpret what investors think of the prospects of a company. PE ratio can also be influenced by the overall economy. If say the whole economy of the US is growing, the average PE of US companies will be higher due to the expectation of continued growth. During recessions or depressions, PE tends to be low, as people think the economy will shrink and companies will make less money.
Since Apple is a massive company, it does not grow very quickly. We can see this in the Forward PE of AAPL which is currently 12.68. People think AAPL with grow in a positive direction (make more money) in the next 12 months than they had in the previous 12 months. Hence Apple’s Forward PE being lower than the conventional PE that uses historic data. But of course, people can be wrong. Samsung may make a new phone that kicks iPhones out. The iWatch may fail. The converse is also true, the iWatch may explode and be on every person’s wrist. The new iPad may be the best yet and everyone buys one. But by looking at the current share price and PE, we can get an overall sentiment as to what people think the company will be worth in the future. Chipotle on the other hand has a PE Ratio of 41.75. This is due to the massive growth Chipotle has reported consistently every financial quarter. If the growth continues at this rate, the Earnings per Share will increase in the future and people who own the company now will make money as the shares will be worth more. But, that is all a big if. The PE can give us the sentiment investors feel towards a stock and their predictions on where it is going.
We can see a lot of what drives the stock market is prospective thinking as we see with the high PE’s. People are willing to pay, on average, 15 times the current earnings for the prospect of future earnings. This is also reflected in some quarterly reports. A company may report a bad quarter where their revenue was less than what was expected. But rather than the stock price going down it goes up! This is often due to the company’s prospective guidance about the future. Revenue may have gone down in the last quarter but maybe a new product is launching in the next quarter. Or a legal case was settled and moving forward legal fees will no longer hinder profits. “We don’t care where a stock has been, we care about where it is going.” This phrase is often said by former hedge fund manager Jim Cramer (who you best know as that guy shouting and flailing on CNBC).
I bring all of this up because predicting the future can be very hard. It is completely uncertain. We can use historic data to better inform our decision, but until we reach the future we cannot be sure of anything.
Now our brains are quite good at prospective thinking. We have the ability to plan our next action and layout our days, weeks, and even entire lives. The hippocampus is a brain region that likely plays a large role in this. It is capable of not only remembering the past but also representing the future. When rats are navigating around a box for food, the hippocampus represents future paths that end where the food is. While rats explore and carry out tasks, the hippocampus is constantly sweeping ahead of rats, representing the upcoming paths to goals. During sleep the hippocampus represents areas that are blocked off to a rat but contain a reward that the rat can see, “dreaming” of places the rat wishes he could go. Another region of the brain likely aiding in this process is the prefrontal cortex. The prefrontal cortex is the front of the brain thought as the executive function center. It is implicated in decision making, valuations, abstract thought, social cognition, problem solving, and importantly for us, planning. For example, the prefrontal cortex in humans prospectively represents task responses. Some brain activity can also be predictive of future activity, either within the same brain structure, in interconnected structures, or even predictive of the organisms behavior.
There are many ways in which prospective activity in the brain can be measured and include looking at individual cells in the brain, discrete groups of cells, large populations of cells, and how different brain regions are communicating with each other. The aim of this project is to try and apply analysis I use on brain activity for analyzing the stock market. First I will work on ways to translate stock market activity into activity similar enough to brain activity for my analysis to work. Second, I will work through different types of analysis at different levels. These levels may be time (analyzing a few days of data to decades to minutes) or content (stock price, PE ratios, stock volume, short selling, etc). Finally, we will see if any analysis gives meaningful insight into how the market works and if we can go about predicting future market activity. Click on any of the blue steps below to see what I’ve been doing. (if a step is black, I am not yet there)
Step 1: Translating stock market activity to resemble brain activity
Step 2: Analyzing brain like stock market activity
Step 3: Interpreting results