Setting up

Share prices are normally expected to trend gradually higher as a reflection of the growth of fundamental features that include earnings and dividends. Those features are, in turn, driven over the long run by rising productivity (i.e., technological innovations) and expanding populations. In bubbles, however, the rate of increase in the realized current price runs ahead faster than even the rising but highly uncertain changes in expected earnings and dividend streams. The relationship between the risk premium and the price variance thus changes conspicuously.

In any market, there are two moving pieces to watch. The first is the change in expected earnings and dividends – the fundamentals – and the second is the valuation applied to the fundamentals. It is, for example, entirely possible that earnings and dividends rise as expected, but that share prices do not, or it could be the other way around. The valuation aspect is what makes the difference.

This valuation aspect may change as a function of investor psychology, direction of change of interest rates, political events, and so forth. Whatever the reasons, changes in valuation are reflected in changes in the risk premium. When optimism is prevalent, the risk premium is low, and vice versa. Thus, a change in the risk premium in either direction will, often at great relative speed, act to either amplify or dampen any price changes that are based purely on the slower-moving fundamental factors.