Ben Bernanke’s testimony in Congress yesterday got me thinking.
The stock values reflect not so much the fundamentals, the long-term profitability of the economy, but they also reflect investor attitudes about risk and uncertainty which right now are at very high levels.
The efficient market hypothesis states that market prices are informationally efficient. That means that stock prices reflect all knowable information. This implies that market participants acting together determine stock prices that reflect all knowable information. Individual market participants, however, make discrete decisions that can wildly oppose each other. In the case of banks like Bank of America or Citigroup, some investors believe the banks will survive as public entities and some believe that they will be nationalized, wiping out shareholder value. The aggregate pricing then reflects a value that takes into account probabilistic outcomes. The most commonly used example of this is the calculation of market implied Fed funds rates. If you have ever heard a pundit say something like, “The markets are pricing a 78% chance of a 25 basis point rate cut at the next Fed meeting.” These rates are usually based on the market price of Federal Funds Rate Futures traded on the Chicago Board of Exchange.
Obviously, probabilistic values do not represent full value at some date in the future. While there’s a 50% chance of a head or a tail when you flip a coin, the end result can only be heads or tails. And, this is where the market can present opportunities for investors, particularly when the outcomes that are being bet on involve government policy more than fundamentals. That’s right, I’m alluding to financials – GE, BAC, C in particular – are having their shares slaughtered by the market. Automakers (F and GM), to a lesser extent, are also trading at prices that are more reflective of the probability of failure than true fundamentals. In both cases, government policy will likely determine success or failure and for those with insight into how our current monetary and fiscal policy chiefs think may likely profit greatly off of current market prices.
Those of you who are adept at math will probably see a glaring flaw in my logic here. If the markets are truly efficient, then clearly the most knowledgeable people in the world have already priced securities to a degree that your expectation of return is 0. I admit that my logical approach defies this mathematical truth. But, I guess that’s why I don’t necessarily believe in efficient markets. In fact, I would say the inflation of real estate values to an unsustainable level is a very good example of how the market often misprices assets. For those that do believe in efficient markets, I would say the current market offers some terrific opportunities to with which to flip the coin. There’s one dominant variable which affects prices – the government response to the recession. If there is ever an opportunity to get ahead of the coin flip, it’s today. Further, historically depressed prices mean that reward far outstrips your risk*.
* I define risk and reward on a nominal and not probabilistic basis in this last statement. Many stocks trade >50% below their market determined prices two years ago (implying a potential return >100% when demand returns to long run levels) and the loss on a 0 is always the same, 100%. Probabilistically, your expectation may not be higher, but the result if you do win is likely to be much more tangibly significant.
Full Disclosure: Author is long shares of GE at the time of writing.