For successful investing… the market price movement should be given the most consideration… often greater than fundamentals and valuation…
The phrase ‘market prices reflect everything’ means that, at any moment, a stock’s price reflects all information concerning its business prospect – and every price change then on reflects a change in those prospects. However, this is an incomplete interpretation. Even though the price action reflects the impact of new relevant information most of the time, at certain times the cause of price action could be entirely different. This is because ‘everything’ includes both the good and bad behaviour of investors. The expectation that investors always act rationally based on analysing all available, relevant information is far from true. At certain times, particularly when there is a general paucity of rationality among investors, the behaviour of market prices might completely diverge from changes in its business prospects.
For instance, during periods of widespread speculation, rather than reflecting the change in prospects, a price change might reflect the irrationality-fuelled exuberance that often grips market participants. At other times, it might be the foreknowing ability of the market – the ability to know events before they occur. If so then an unexpected positive price gain could be stock prices incorporating in them some positive information that is not yet revealed but will do so soon; and vice versa, a price drop could be stock prices incorporating in them some negative information soon to be revealed. Therefore, to make sense of the significance of each price action, it is essential that, rather than taking it at face value, an astute investor needs to investigate the causes and forces behind each market price change. But before we proceed, we must ask ourselves: “Is interpreting the market price action essential to successful investing?”; “Aren’t a stock’s fundamentals and valuation the only things that matter in the long run?”
Yes! Fundamentals and valuations indeed matter, especially in the long term. But they have serious limitations potent enough to cause a considerable detrimental impact on our investment return. This is because fundamental analysis and valuation of stocks are done using past and present information available to us. However, the present and past don’t have a commendable record in deciphering the future direction of earnings growth and profitability – the principal drivers of stock prices.
Normally, a stock with high earnings growth and profitability will command a higher valuation in the market. But going forward, if it experiences an earnings slowdown, its profitability will decline. At the reduced profitability, it can’t command the earlier higher valuation – so the stock’s price declines and adjusts to a lower valuation. In contrast, a stock with low earnings growth and profitability will command a lower valuation. But going forward, if it experiences an earnings acceleration, its profitability will improve, consequently expanding its valuation and ultimately driving its stock price higher – here, the stock gain outpaces the earnings growth due to the expansion in valuation. Meanwhile, stocks with steady profitability, whether high or low, will see their stock price keep up with their respective earnings growth.
In all the above scenarios, the initial profitability and valuation had little bearing on the stock’s later performance. In other words, the past or present performance is not a reliable guide to the future performance. We could know how a stock might react to a particular earnings trend, but what kind of earnings trend would unfold in the future cannot be deciphered out of past and present information.
From an investment return perspective, at one extreme, we strive to avoid stocks that will experience a decline in profitability and valuation. At the other extreme, we yearn to own stocks that will experience an increase in profitability and valuation. But how could we foretell which stocks will experience a decline or increase in their respective profitability and valuation in future? As we have seen, fundamental analysis and valuation won’t be of much help here. This is where the utility of interpreting market price action is. This kind of uncertainty could be resolved, though not entirely, by interpreting market price action.
We all know that it is the buying and selling decisions by investors that cause a stock’s price to rise or fall. Even though fundamentals and valuation strongly influence those decisions, factors outside them could also influence stock prices. Put differently, the force underlying every stock price movement is the desirability and capability of investors to bid prices up or down. However, the desirability and capability of investors can sometimes diverge so widely from that informed by fundamentals and valuation.
Sometimes, despite favourable fundamentals and valuation, the investor’s ability to act could be constrained – even if he wishes to act. Lack of investable capital, restricted access to capital, tightened margin money requirements, an increase in interest rates and the consequent increase in the cost of capital are a few situations. Despite being positive on markets, an increase in living expenses might compel one to tap his investment corpus, forcing him to sell stocks: an action contrary to his market outlook. Regulatory actions that impede capital flow into the market can dampen stock prices. Other times the investor might have the necessary capital but his desirability for a particular stock, sector, or market might be depressed. In the present financial markets where a fast, frictionless flow of capital across borders is possible, when another market or asset becomes more attractive, he may divert his attention and capital towards them.
During extreme optimism, his desirability and capability are so high, that prices keep rising despite weakening fundamentals and high valuation. Similarly, during extreme pessimism, he has low desirability and capability, so prices keep falling or stay depressed despite low valuation and improving fundamentals. This is why interpreting market price action becomes imperative. It can inform us about the desirability and capability of investors to bid prices up or down. But these factors outside of fundamentals and valuation are so humongous and scattered that keeping track and making sense of them is so gigantic as to be unfeasible. However, since all these factors are reflected in market prices, interpreting market prices is a more plausible route to get a better sense of them.
To reach the right conclusion while interpreting the market price action, two things matter. First is the context of the market price action. Another is the expertise in interpreting those market price actions.
It is only within the context in which the price action happens could we have a proper understanding of it. Say a stock, whose price has been rising rapidly, reports poor results for a quarter when both its revenue and profit declined. However, rather than decline, if the stock price continues to rise, then it could mean that the market is euphoric – and hence should be stridden cautiously. Or else, if the poor result comes on the back of a series of good results, the market might be signalling that the poor result hasn’t disrupted the positive trend in earnings.
Suppose another situation in which a stock that has been in a long decline due to poor earnings starts exhibiting strength (in both price and volume) without any earnings recovery evident. This could mean that the price has hit a bottom, and from then on, the stock’s prospects are to get better. To clarify, although earnings recovery is not evident, it is imminent. An unusual upward or downward price movement with no relevant information conspicuous enough to explain the price action might be indicative of some forthcoming significant event – either for the good or for the bad.
The ability to recognise these price actions, and most importantly, make sense of their significance, is essential for successful investing. It is more of an art than science. It requires an understanding of the underpinnings of financial market functioning gained through years of study and experience in markets. Therefore, alongside the context, expertise is the other ingredient that goes into making the right conclusion while interpreting market price movements.
The attempt to infer insights out of market price action could go wrong when done by a person who lacks the necessary expertise for that. One sign of inexpertise is forming conclusions about the significance of a market price action through a single line of thought with a single set of data. Nothing could be pernicious than that – a decision arrived at through a single line of thought guided by a single set of data. Avoid it. Ideally, the conclusion should be tested from other available angles using different sets of data. Here, discord and dissent among possibilities should be welcomed and encouraged, rather than homogeneity and uniformity.
Although the study of the market price level and its movement requires the most consideration, relying solely on it for your investment decisions would be unwise. For effective investment decision-making, make sure that alongside the study of market price action, other factors such as financial performance, valuation, and other important economic variables aren’t sidelined or neglected.
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