Where Were We?…
Continuing on from the conversation about fair-value weighting versus market-capitalization weighting, we already know that we can never construct a fair-value weighted index or portfolio simply because no-one can know the true fair value of a company – ultimately, the best we can do is guess – which is basically the stock market’s function. It is a compilation of the current guesses as to the fair value. Sometimes it seems right, and sometimes it seems just plain loopy.
We’re Just Guessing In The Short Run
Based on financial theory, most guesses as to the price of a stock is based on another guess: a guess of the future earnings of that company (and it’s profitability). If you go back and read the series on P/E ratios you’ll see that growth stocks (companies’ whose earning are expected to grow rapidly) can have very high market capitalizations. If those earnings expectations are not met in the future, or the future expectations change negatively, then these same companies’ stock prices can fall dramatically. I think most people would agree that a company’s stock price probably oscillates above and below it’s fair value throughout a company’s lifetime. Over long periods of time, and across thousands of stocks, the pricing errors probably cancel each other out for the most part.
The discussion above basically explains the famous Benjamin Graham quote:
“In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”
Again, as long as we are talking about long timeframes, the market eventually comes to it’s collective senses. The short-term is another story though – investor psychology (fear and greed) can drive the market to excesses. That the market behaves like a weighing machine in the long run is a testament to the notion that capitalism works, but you can’t say that confidently unless you have a long time horizon.