Wednesday, 19 November 2008

Stock markets discount everything

Wednesday November 19, 2008
Stock markets discount everything
Current prices reflect all potential returns and risks

A LOT of investors find it difficult to predict the stock market’s movement. They cannot understand why whenever the market is faced with a lot of bad news, instead of tumbling, it goes up.

Each time the market has a lot of good news and they feel that it is the right time to buy stocks, the market drops. As a result, investors always enter the market at the wrong time and end up buying stocks at higher prices and selling them at lower prices.

In this article, we will look at whether the current market prices are reflecting all the information, including the good and bad news.

According to Eugene Fama, a market is considered efficient if the current market prices reflect all available information.

In an efficient market, investors will not be able to make money from the information they own as all the potential returns or risks are already reflected in the stock prices.

If you are an efficient market believer, you will believe it is not possible to make money from whatever available information such as stock prices, trading volume, the company’s financial statement or any insider information.

The best price to purchase any stock will be the current price as it reflects all the potential returns and risks involved in the company.

Recently, the Dow Jones Industrial Average surged from a low of 8,175.77 on Oct 27 to a high of 9,625.28 on Nov 4, the day of the US presidential election.

Despite higher stock prices, not many investors dared enter the market as they were uncertain if Barack Obama could win the election.

Obama’s landslide victory led many investors to believe it was the right time to purchase stocks but the Dow tumbled 486 points to close at 9,139.27 the very next day after the presidential election.

Our local investors, who rushed in to purchase stocks in the belief that the US market would soar following Obama’s victory, were deeply disappointed as the market did not behave as predicted.

The main reason behind this phenomenon was because the positive news of Obama’s victory had already been reflected in stock prices.

As a result, when the actual incident happened, the market tumbled instead of surging. Besides, after the short-lived euphoria on the US election, the US stock market still needed to reflect the poor fundamentals of the US economy and the possible economic recession. Hence, whenever we intend to take position on any positive or negative news, we need to determine whether that information is already reflected in the stock prices.

On Monday, even though the official data showed that Japan had slipped into recession, Japanese stocks shrugged off the news by closing higher.

Most investors could not understand why Japan’s stock market could close higher on such big negative news. Again, the main reason for this was the news on possible recession had already been reflected in Japanese stock prices.

In fact, some traders or investors might have over-reacted to the economic recession. Hence, when the Japanese government announced the actual numbers, investors reacted positively to the numbers as not being as bad as what they had predicted.

Since August 2007, markets in the Asia-Pacific have experienced several waves of massive selling. Each time the Asia-Pacific and European markets tumbled by more than 5%, raising investor concern over further crashes on the overnight US market, in most instances, the Dow would close higher as most of the negative news had been reflected in the stock prices.

Hence, we should not be too pessimistic whenever we encounter a lot of negative news. We need to sit back and think whether this negative news has been reflected in the stock prices.

Sometimes it may be the right time to purchase instead of selling stocks. In most instances, as a result of our panic selling, some investors end up regretting they sold the stocks too early. If they had more patience and had waited for a few days, they might have been able to sell at higher prices.

In conclusion, whenever we receive any positive or negative news, whether we are able to take advantage of it will very much depend on whether the information has been reflected in the stock prices.

If the stock prices have reacted to the news prior to the announcement, investors will not be able to benefit from the information.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

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