The stock market is an unpredictable beast. And many investors, even those who are already seasoned and accomplished, fail to gauge its performance. However, here are four of the ways you can try to gauge the market.
The widely quoted stock market words of wisdom – don’t fight the tape – warns investors not to get in the way of market trends. The assumption is that the best bet about market movements is that they will continue in the same direction. This concept has its roots in behavioral finance.
With so many stocks to choose from, why would investors keep their money in a stock that’s falling, as opposed to the one that’s climbing? It’s basically fear and greed.
According to studies, mutual fund inflows are positively correlated with market returns. Momentum plays a part in the decision to invest, and when more people invest, the market goes up, encouraging even more people to buy. It’s a positive feedback loop.
Experienced investors that have already seen many market ups and downs often take the view that the market will even out over time. Historically, high market prices often discourage these investors from investing, while historically low prices may represent an opportunity.
The tendency of a variable, such as stock price, to converge on an average value over time is called mean reversion. The phenomenon has been found in several economic indicators, which are useful to know, including exchange rates, gross domestic product growth, interest rates, and unemployment. Mean reversion may also be responsible for business cycles.
In 1965, Paul Samuelson studied market returns and found that past pricing trends had no effect on future prices and reasoned that in an efficient market, there should be no such effect. His conclusion was that the market prices are martingales.
A martingale is a mathematical series in which the best prediction for the next number is the current number. The concept is used in probability theory, to estimate the results of random motion.
In stock option pricing, stock market returns could be assumed to be martingales. As per this theory, the valuation of the option does not depend on the past pricing trend, or on any estimate of future price trends. The current price and the estimated volatility are the only stock-specific inputs.
A martingale in which the next number is more likely to be higher is known as a sub-martingale. In pop literature, this motion is known as a random walk with an upward drift. This description is consistent with more than 80 years of stock market pricing history. In spite of the many short term reversals,the overall trend has been consistently higher.
The Search for Value
Value investors buy stock cheaply and expect to be rewarded later. Their hope is that an efficient market has underpriced the stock but that the price will adjust over time. The question is if this really happens and why would an efficient market make this adjustment.
Research suggest this mispricing and readjustment consistently happens, although there’s really very little evidence as to why this happens.