[Let "the market(s)" mean the U.S. equity markets in this article, I'm hardly qualified to write about anything else]
I guess I've only been closely following the markets for less than a year. Online tools make it easy, addictive. I've had money in the markets for half of that, and I first took an actual finance course at the beginning of October. Things that are systematic in nature have always attracted my interest, and building up ordered, logical systems seems to be part of the way I've always thought about things. I remember complicated rule-making in games with my little brother.
So, trying to dissect and understand the markets is natural to me, and that has been tough. I generally learn stuff fairly quickly when I really concentrate on it. Presumably other people have had this same sort of experience, but I'll touch on that later. (I wonder if committing some of these thoughts to writing will help this process in any way.)
The market basically gives a price to things. It's a particular thing that we're all interested in: little bits of corporations. Fine, valuing a little piece of a corporation should be easy. Look at the whole company. Assets minus liabilities, now provide some estimates for growth and potential earnings. You get a whole stream of future earnings. But the further away those happen to be, the less they are worth today, so let's discount the whole thing to the present (as is usually done in financial calculations). Divide by the number of shares and you have a share price. Of course, none of these numbers is absolute, so there will be a range of possible prices.
As I write this, I think I'll attempt to value the General Electric Company. Two keystrokes and I get a ton of important facts that will enable me to do this if I want to. Cool! Let's see. There's a book value of $11.88. The company has lately earned $2.88 a share, and paid out a $1.40 dividend, every year.
First, suppose they continue to do this indefinitely. Treasuries yield 5.516% right now, so let's try using this as a discount rate. We mathematicians can do the infinite sum of discounted earnings instantly (ask and I'll tell you how) to get $52.21. There we go, let's add that to the book value. The company is worth $64 per share. There are 3.8 billion shares, so this is pretty impressive -- a $243 billion company.
But right now it trades for 107 5/8. So something's wrong.
The theory of efficient markets states that I'm wrong, and anyone who values the company at something besides $107 5/8 is also wrong. That is, the value of GE, a message from a financial god, is $325 billion. When a change happens, the price will change. (Purists will note that there are different versions, depending on whether only public information is assumed, or private information.) Basically, the theorists say that I don't have to worry at all about valuing the firm -- if I want to reap the benefits
My calculation above is pretty likely to be wrong. I wouldn't go out and short GE based on it. However, I could've done a lot better. It's pretty naive to discount with the 30-year Treasury yield (since I couldn't borrow money at that rate, for example). Most importantly, I assumed no change at all in earnings. I don't really think that in 2029, GE will earn exactly $2.88 again. And maybe there's some debt, and maybe some of their projects are very risky, or some of the earnings come from sales of their jungle banana farms and can't be assumed to be repeated, etc.
So yeah, $107 5/8 is closer to the value of GE. Maybe I assume a 2% growth rate per year or something, that would give me $103, and I guess some factor like the above, or one I haven't thought of, explains the extra five bucks (a paltry $16 billion).
But, wow, the value of GE dropped by 3.48% today. That's not encouraging. That's ten billion dollars! Maybe some new economic information indicates that they will make a little bit less for the near future. The only news release today is "GE Capital Names Daniel Mudd President of GE Capital Japan", and I hardly think we can blame it on that. This market is smart; it's discovered something that I just can't track down.
Whatever it was, if it happened overnight, GE should've opened at 107 5/8 and stayed there. It probably did, so I'll just glance at a chart to be sure. whoa! The price changes every few seconds! It looks like I've vastly underestimated the intelligence of this market. Stocks move all over the place, all the time. Global events affecting the values of companies (like, say, Alan Greenspan sneezing) are being instantly reflected in the price, so the theory goes. Yes, I can't observe them and act on them before the price moves to fix them.
This unbelievable discovery leads me to conclude (instantly!) that I can't win. But, I hope for overall growth in stock prices, and statistical evidence supports my claim. So, my best bet is to inject my money into something like Vanguard Total Market and wait a few decades. This minimizes the risk of any individual company hurting my performance and lets me soak up the wonderful things that will happen to every Wilshire 5000 company. (If I had taken $10,000 and done this in 1979, the mountain charts shows that I'd have a quarter million.)
Well, enough of this partial-education-partial-ridicule stuff. As comforting as it is, I don't buy theories that these crazy stochastic prices are reflecting real changes in value. In textbooks, I haven't seen solid evidence that they really do. There are some compelling stories (like the price of orange juice futures being a better predictor of overnight freezes than weather forecasts posted long after the close of the exchange). I don't see it in individual stocks, though.
Why? Well, another implication of the EMH (efficient market hypothesis) is that these movements are random (geometric brownian motion) and past prices don't serve to predict future prices. Only the present price does that -- and the mean future price is a time-adjusted (reversing my discounting above) version of the current price. The theory would imply that my best guess on any given day of GE's close-to-close price change is almost zero.
A lot of people have gone through this same thought process in attempting to understand the markets (and profit from this understanding). I see a few different views (call them investment styles if you want) that people gravitate towards (all of which merit their own articles):
I think what I'm currently doing is trying myself to look at the merits of all these different views. There is ample reason to believe that I have all the information in front of me that I need to generate excellent, outperforming returns. The truth lies somewhere between all these different styles, for certain. I can already see from my observations that simple, easy-to-understand ideas and knee-jerk reactions tend to lose people money.
You won't see my money tied to the Wilshire 5000. While the strategies available to me at the moment are very limited, and my current outperformance isn't likely to continue, it's a hell of a lot of fun. What I want to do is expand the toolset I have available and look for ways to quantify things that I see happening in the market, in the hopes of gaining some predictive power. After that, though, there is still a major obstacle facing me: getting the discipline to use whatever edge I can gain to my advantage. I have more to say about this, but I'll end it here with yet another point to ponder:
I once heard a trader say that every loss of his is basically a tuition payment. That probably makes a pretty expensive education.