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• That the (fundamental) "value" of a share is closely correlated (or even equal to) its market (stock exchange or transaction) price;

• That price movements (and volatility) are mostly random, though correlated to the (fundamental) "value" of the share (will always converge to that "value" in the long term);

• That this fundamental "value" responds to and reflects new information efficiently (old information is fully incorporated in it).

Investors are supposed to discount the stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Capital gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations.

Yet, these theories and equations stand in stark contrast to market realities.

People do not buy shares because they expect to receive a stream of future income in the form of dividends.

Abstract

A very slim minority of firms distribute dividends. This truism has revolutionary implications. In the nullity of dividends, the foundation of most - if not all - of the financial theories we employ in order to determine the value of shares, is falsified. These theories rely on a few implicit and explicit assumptions:

• That the (fundamental) "value" of a share is pretty near correlated (or even equal to) its market (stock exchange or transaction) price;

• That price movements (and volatility) are mostly random, though correlated to the (fundamental) "value" of the share (will without stopping converge to that "value" in the long term);

• That this fundamental "value" responds to and reflects new information efficiently (old information is fully incorporated in it).

Investors are supposed to discount the stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies engage in the distribution of dividends, theoreticians were forced to deal with "expected" dividends rather than "paid out" ones. The best gauge of expected dividends is earnings. The higher the earnings - the more likely and the higher the dividends. Even retained earnings can be regarded as deferred dividends. Retained earnings are re-invested, the investments generate earnings and, again, the likelihood and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a yield - using the earnings yield and other measures. It is as though these earnings WERE distributed and created a RETURN - in other words, an income - to the investor.

The reason for the perpetuation of this misnomer is that, to all current theories of finance, in the beggary of dividends - shares are worthless. If an investor is never likely to receive income from his holdings - then his holdings are worthless. bastard type gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations.

Yet, these theories and equations stand in stark contrast to market realities.

People do not buy shares as things go they expect to receive a stream of future income in the form of dividends. Everyone knows that dividends are fast well-shaped a thing of the past. Rather, investors buy shares inasmuch as they hope to sell them to other investors later at a higher price. In other words, investors do expect to realize income from their shareholdings but in the form of controlling gains. The price of a share reflects its discounted expected logotype gains (the discount rate esprit its volatility) - NOT its discounted future stream of income. The volatility of a share (and the distribution of its prices), in turn, are a measure of expectations regarding the usability of willing and able buyers (investors). Thus, the expected method gains are comprised of a fundamental element (the expected discounted earnings) inured for volatility (the latter immediate a measure of expectations regarding the distribution of existence of willing and able buyers per given price range). Earnings come into the picture merely as a yardstick, a calibrator, a gauge figure. premier gains are created when the value of the firm whose shares are traded increases. Such an increase is more often than not correlated with the future stream of income to the FIRM (NOT to the shareholder!!!). This strong correlation is what binds earnings and top gains together. It is a correlation - which might indicate grounds and yet might not. But, in any case, that earnings are a good proxy to paramount gains is not disputable.

And this is why investors are obsessed by earnings figures. Not insomuch as higher earnings mean higher dividends now or at any point in the future. But seeing that earnings are an excellent predictor of the future value of the firm and, thus, of expected first-string gains. Put more plainly: the higher the earnings, the higher the market valuation of the firm, the bigger the willingness of investors to purchase the shares at a higher price, the higher the supply gains. Again, this may not be a impelling bond but the correlation is strong.

This is a philosophical shift from "rational" measures (such as fundamental inspection of future income) to "irrational" ones (the future value of share-ownership to various types of investors). It is a transition from an efficient market (all new information is immediately present to all rational investors and is incorporated in the price of the share instantaneously) to an inefficient one (the most important information is forever lacking or missing altogether: how many investors wish to buy the share at a given price at a given moment).

An income driven market is "open" in the sense that it depends on newly acquired information and reacts to it efficiently (it is highly liquid). But it is also "closed" being it is a zero sum game, even in the deficit of mechanisms for selling it short. One investor's gain is another's loss and all investors are in every instance hunting for bargains (because what is a bid can be evaluated "objectively" and independent of the state of mind of the players). The distribution of gains and losses is pretty even. The general price level amplitudes back an anchor.

A magisterial gains driven market is "open" in the sense that it depends on new streams of crown (on new investors). As long as new money keeps pouring in, feet gains expectations will be maintained and realized. But the mark of such money is finite and, in this sense, the market is "closed". Upon the exhaustion of present sources of funding, the hiss tends to torrent and the general price level implodes, without a floor. This is more simply described as a "pyramid scheme" or, more politely, an "asset bubble". This is why portfolio models (CAPM and others) are unlikely to work. Diversification is useless when shares and markets move in tandem (contagion) and they move in tandem cause they are all influenced by one critical factor - and only by one factor - the occurrence of future buyers at given prices.

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