Forecasting share prices now calls for a combined approach – Natixis

There are two theories to determine a stock market index target. The fundamental approach and the portfolio rebalancing approach. Strategists at Natixis combine these two approaches to define an overall (fundamental and portfolio) approach to share prices.

Combining the two approaches

“The fundamentalist approach to determining share prices simply says that share prices must converge towards their fundamental value, which is the discounted sum of future dividends. If this approach is the only one that explains share prices, the equity risk premium is therefore expected to be relatively stable and does not vary according to the economic cycle, monetary policy, etc. However, high variability in the equity risk premium suggests there are determinants of share prices other than their fundamental value.” 

“The idea of portfolio rebalancing approach to share prices is that savers desire a particular structure for their wealth between the various asset classes (money, bonds, equities, real estate). When monetary policy becomes expansionary, there is strong money creation and the proportion of money in wealth increases. Savers then rebalance the structure of their portfolios by using the excess money they hold to buy other assets. At equilibrium, this drives up the prices of other assets, increases the proportion of other assets in wealth and rebalances the structure of portfolios. Indeed, we can see that strong money creation is associated with a sharp rise in stock market indices.”

“When we combine both approaches, we find that the equity risk premium decreases as the proportion of money and bonds in wealth increases. The idea is simple: if the proportion of money in wealth increases, portfolio rebalancing leads share prices to rise above their fundamental value.”