Intrinsic + Fashion + Exuberance Values

In my study of tides, there are higher high, lower low, higher low, and lower high. You stock guys use similar words like people studying tides.

Tides are usually controlled by two forces: gravity of the Moon and that of the Sun. Since the two forces are not exactly aligned with each other, so the combinations of high & low appear. When the Sun and the Moon are on the same side, higher high and lower low are created.

I assume the stock markets are controlled by more than two forces (let's assume there are N forces), so there must be N^2 combinations of high and lows. Since the number of combinations increases proportionally to the square of the number of factors, it will become difficult to estimate the impact of each factor.

A friend of mine who studied the market using factors analysis, he concluded around 1998 that there are three independent factors control the market. In this case, N = 3. So we would have 9 combinations of high-mid-low.

Following this line of logic, I proposed three controlling factors which may contribute the market movements and volatility.

(1) Economic factor is the number one factor. Since Economics is the scientific study of the economy, so anything that is covered under the big title of Economics may contribute to the stock market movements. These factors include the supply-demand mechanism as you mentioned. One is likely to invest in the stock market because I think I know economics.

(2) Psychological factor is the second factor. One of the reasons many people participate in the stock investment is the fear of loosing out the potential opportunities. One might invest without any real understandings of the economics behind the stock market. Many psychological factors such as greed and fear are good examples of psychological factors.

(3) Societal factor is the third factor. Another reason to market changes is that of the society. One might invest in stocks because she or he has a fried who has given him/her a good tip about some stocks. There are many social factors which may contribute to driving people into investments. Examples of social factors are mass media, families, friends, coworkers, etc.

So overall, the economic value of stocks is the real intrinsic value of the stock. The societal value of the stock is like the fashion value. The psychological value of stock is the exuberance value. So I propose a three-factor model for stock values:

Stock Price = Economic Value + Societal Value + Psychological Value

Or alternatively,

Stock Price = Intrinsic Value + Fashion Value + Exuberance Value

Any stock analysis should be able to decompose stock prices into three sub-values so that one can judge the real value of the stock.

Since the economic or intrinsic value is the most stable value, it will not change frequently over time. Value investors are mostly concerned with estimating the intrinsic value of stocks. The Societal or fashion value can come and go just like fashion in consumer products. The so-called sector rotation funds are established based on the movements of fashion among different industry sectors. The psychological or exuberance value is the direct results of the crowd. To me it is the most unstable value to account for. Many trading methods are the most direct applications of psychological factors.