Everyone seems to have an explanation for daily fluctuations in the stock market. Somehow, not everyone makes lots of money exploiting these fluctuations. In the long term, the most coherent belief in the market is that the price of a stock will reflect the business value of the company. In the short term, anything goes.
The Efficient Market Hypothesis
If you dig into the theory of investing, you'll find a lot of unique beliefs.
For example, the efficient market hypothesis suggests that the market as a whole tends to find the best price for stocks all the time. At any point in time, the price of any stock reflects all of the information available about the stock and its business.
At first glance, this makes intuitive sense. The market is a weighing machine. At any point in time, the price of a stock represents an agreement between buyers and sellers. The most recent successful trade represents a price where someone willing to sell a stock found someone willing to buy that stock.
For a huge stock such as Ford, Coca-Cola, or Google, millions of shares trade hands every day. Thousands (hundreds of thousands?) of buyers and sellers make trades every day. For everyone who's bullish about the stock and wants to buy, there's someone else bearish who wants to sell. You can see those trades take place and the price fluctuate. Does the price really reflect all of the knowledge about the stock?
The theory is interesting. How does it work in practice?
Assumptions of the Efficient Market Hypothesis
If you take the EMH to its conclusions, you're unlikely to find undervalued or overvalued stocks because the current price of any stock should be pretty fair.
One flaw in the efficient market hypothesis is that it assumes that the most recent transaction of the stock reflects all of the information available about the company. For a sale to happen, a buyer and a seller must actually complete a transaction. They're doing so based on market information.
Think about it this way. If one person believes that Coca-Cola is about to quadruple in price and wants to buy a billion shares for $0.01 apiece, what are the chances of finding enough sellers to fill that trade at that price?
Is an offer to buy at $0.01 a legitimate piece of information about a stock? Maybe it's not a realistic view or a realistic offer price, but it's information.
Think this through. One person believes something outrageous. If that person found sellers, would those transactions depress the value of the stock? Would other people jump on that trend? (What if people had automatic trading rules to sell their shares if KO went below a price threshold? What if several thousand of those rules all flooded the market with offers to sell at a low price? What does that represent about the company?)
Contrarily, what if I believe that my shares of KO are worth $100 apiece and have a standing offer to sell them at that price? That may not reflect majority opinion about the market, yet what has the efficient market decided when I successfully complete a trade at that price?
Those are surface criticisms, however. A bigger problem of the EMH is that it fails to account for how easy it is to buy or sell shares. Without enough buyers or sellers, how can any price represent an equilibrium which accurately reflects investor sentiment? If only 3000 shares of Jewett-Cameron trade hands every day, is the sample size enough to represent consensus? Even if markets and investors agree on the value of a stock agree, will a transaction actually take place?
One of the worst assumptions of the efficient market hypothesis is how it overvalues market price in general. What does market price mean? The market price of a stock is that price, at a fixed point in time, where a buyer and seller agree. That's it. What does that tell you?
The Efficient Market Criticism of Value Investing
Proponents of the efficient market hypothesis have similar criticisms of value investing. The most direct argument is that the market pricing model offers few chances to find inefficiencies. In other words, you're not going to see a stock underpriced long enough to jump on a good value investing opportunity because the market will quickly correct itself. Similarly, you won't find overpriced stocks, because they'll be sold at a profit.
Do these arguments hold up? The former is circular ("efficiency means that there are no inefficiencies") and the latter requires strict short-term thinking ("I've made a profit on this stock, therefore there's no reason to keep it").
Economics presumes the existence of a perfectly rational actor, but who is perfectly rational in the ways that economists prefer?
If you're thinking "That's not the biggest problem with that argument," you're right! Perhaps it's not obviously rational to hold on to a stock that's made a sufficient profit, but to make that assertion, you have to understand ideas such as rational and sufficient profit.
Can any single analysis of the price of a stock account for investors as diverse as the pension fund of an American state, a day trader, an elderly retiree, and a 22 year old who's directed all of the contributions of her 401(k) into a S&P 500 index fund? Can the irrationalities of one position counter fully the irrationalities of other positions?
If I'm holding KO because I bought it at $6 per share and want to sell it at $60 per share, what does that say about the underlying value of the stock? If 90% of investors are waiting for a best-case financial forecast scenario that never comes true, what then?
Intrinsic Value Versus Efficient Markets
Global financial insecurity may mean that fewer people buy sugary drinks (or automobiles or gasoline or yachts) than if the global economy were flying high.
What does that mean in 2018? What did that mean in 2008?
Can you really condense that belief into a single price all day, every day? Can that price really be correct? After all, not everyone with a stake in the price of a stock makes an visible economic decision about that stock every day. Some people buy and hold for years, quite happily.
Meanwhile, the intrinsic value of a stock—the underlying business, its assets, its debt, its ability to make revenue on invested capital—continues despite investor sentiment. Of course, investor sentiment may affect the business's ability to take on short or long term debt, to approve plans which require shareholder votes, and to make other management decisions—but these are discrete events, not continual votes in a second-by-second popularity contest.
How Efficient is the Stock Market?
Does that mean the stock market is inherently chaotic and inefficient? No. Over time, successful businesses thrive. Unsuccessful or unscrupulous companies go out of business. A well-managed business may have lean years and great years, but it'll continue making money for its investors. Similarly, a failing business may descend into penny stock status before going bankrupt.
Unsuccessful businesses don't last.
There will be inefficiencies in the market. There's incomplete information about stocks. There are fears. There are structural reasons why large players in the market (pension funds, hedge funds, institutional investors regulated by the SEC) can only take limited positions for limited times. More than that, there's asymmetry all over.
I may believe that Berkshire-Hathaway is the best investment position I could take but I might not be able to afford $200k per share right now—or no one might be willing to sell at that price.
Value Investors Find Market Inefficiencies
If the market is relentlessly and maddeningly and unpredictably inefficient, you can still make money investing. Step one is to identify inefficiencies.
The second step is determining your taste for profit. Are you a buy and hold investor? Are you willing to be more active and trade a few times a year, when you've made your target amount of profit?
There's no secret formula to pick profitable stocks, but if you stick with intrinsic value, pay attention to earnings, and look at how well companies turn investor money into accountable revenue, you may be surprised at how many opportunities the so-called efficient market leaves available.
More Articles about Investing
Most Popular Articles