Over the past two years since we launched Triobe Management, I have been intrigued by observing and learning about how the stock market works in general. I figured that it would take understanding this at a minimum to be successful at managing investments in the stock market. Most people understand the general operation of the stock market as a place where many investors come together to buy and sell investments. However, I have come to appreciate that there are also underlying forces that one must understand about the markets to achieve any level of sustainable and consistent success, beyond that of the stock market as a whole.
As a key component to the inner workings of the stock market, we must first explore the concept of price discovery, which is a simple concept and likely one that many people take fore-granted. In short, price discovery is the activity by which market participants compute and agree to pricing for a share of stock (or for any asset for that matter). At its core, a share of stock is simply a right to the future earnings and dividends of a company. For example, if an investor knows the earnings per share of a company, say $1.00/share, and they also know that companies in this company's industry are currently trading at a Price to Earnings (also referred to as PE or PE Ratio) multiple of 15, then they can quickly calculate that the price of the company's stock should be trading around $15.00 ($1.00/earnings x 15 PE = $15.00) because this is the market rate for a company in this company's industry. If the current market price is below this level, the investor might consider this company's stock a great deal, and will buy it. However, if the current market price is above this level, that same investor might not buy it because they feel it is overpriced. Either way, the investor's actions help to determine the market price of this stock. Had the investor decided to buy the stock, they would have added to the current level of demand in the market, and most likely the stock price would have stayed the same or risen depending on the balance of buyers and sellers in the market for this stock at that moment. So, this investor performed price discovery, whereby they computed an intrinsic value of the stock and that computation resulted in their either buying the stock or avoiding to buy the stock. If they did not buy the stock because it was too highly priced, their avoidance of buying contributed to there being less demand for the stock than had they bought it, so the price of the stock likely would have stayed they same or declined, again depending on the balance of supply and demand for this stock at this time in the market, absent other market forces. On the seller side, things work in pretty much the same way, only the decision direction is reversed (sell if last trade price is higher than computed intrinsic value, and avoid selling if last trade price is lower than computed intrinsic value).
The approach to price discovery outlined above is simply one example of how market participants might evaluate the price of a stock, and there are countless other ways this can be accomplished among countless market participants. It is not the approach that is entirely important in this illustration, it is more that market participants took some form of action to identify what the price of the stock should be and that this action determined whether they bought the stock, sold the stock or elected to not buy or sell the stock. In the end, the market price is simply the price where equilibrium exists to balance the number of willing buyers and sellers of a stock at any point in time.
Another key component to understand is that the market acts as both an input and output mechanism. It takes input from investors by collecting the multitude of prices at which securities are bought and sold, ideally as a product of many price discovery efforts as described above. Based on this collective activity, the market tells (provides output) market participants what any security is effectively worth at a point in time. So, in theory, market participants perform calculations based on prices, earnings, growth, etc. and then take their calculation results to the market and proceed to buy or sell securities at favorable prices with respect to their computations of fair or intrinsic value or other requirements. Once those transactions are filled, the market publishes that information so that other investors are able to use that data (typically in the form of a "last trade" price) in their computations, which resumes the process or cycle, which we’ll refer to as the “market process”.
As a final key component to understanding how the stock market operates, market participants generally buy or sell stocks at prices based on two primary pricing motivations. The first motivation is the price based on some perspective regarding intrinsic value relative to the last trade price as discussed above. The second motivation is the price based on what they believe that other market participants are going to be willing to buy or sell the security at in the future. The former is indicative of performing price discovery, and this is often associated with a type of factor based investing called "Value Investing". In Value Investing, the investor seeks investments where the current market valuation is lower or ideally significantly lower than their computed intrinsic value, creating a valuable margin of safety in case their computations turn out not to be accurate. The latter is not indicative of price discovery and is more akin to intending to not be the last one without a chair in a game of musical chairs. This is also a form of factor based investing, often referred to as "Momentum Investing" or "Trend Following", where the investor sees that a stock's price is trending in a certain direction and they make a bet that it will continue in that direction for some period of time so the investor can ultimately sell later at a profit. In this case, the investor is not computing an intrinsic value of the stock based on any fundamental data or financial metrics, they are simply buying because of recent stock price movement that they hope or expect will continue. Both types of investing have been shown to be successful over various times throughout history and are widely supported by a vast sea of academic research. Within factor investing, these are almost considered opposite philosophies, but they can also complement each other well in certain situations.
Before we move on, let me acknowledge that market participants also buy or sell stocks on a multitude of other motivations that have nothing to do with those explained above (margin calls, period re-balancing, tax loss harvesting, etc.). Those motivations and the countless others that exist are beyond the scope of this post, but I want to clarify that I believe the two primary pricing motivations above are really the drivers of most stock buying transactions that take place in the stock market.
Now that we've briefly explained the value and momentum stock investing strategies (often generally referred to as Style Factors and specifically as value factor investing and momentum factor investing), let's explore how they drive market results at a high level. Generally, when the stock market is chugging along in an upward and to the right path and there is little volatility, people begin to think that things will go on that way for a long time into the future. When all stocks seem to only go up, people look for those going up the most and buy them. Who needs to worry about computing a PE Ratio or any form of price discovery at all when everything only goes up? The mindset of the investing population becomes a bit greedy and lazy and everyone wants to buy the leaders in anticipation they will continue to outpace the market as a whole. This is when momentum factor investing generally does the best, because the stocks with the most momentum are those that are in the most favor, and everything is well with the world.
Then, all of a sudden, something happens. It could be a trade tweet or a news headline or some political conflict arising in a major oil-producing nation, but something big happens and changes the mood of the investing world. Investors begin to get nervous and quickly analyze their holdings to see how much (if any) margin of safety they have between a computed intrinsic price (such as explained above) and the last trade price. This is when everyone realizes that the Emperor is not wearing any clothes and they begin to sell off their holdings that cannot be substantiated by solid fundamental valuations with a margin of safety. In this situation, everything gets sold off to some degree, but often it goes that the companies with the lowest valuations sell off the most and fastest as they tend to be the weaker companies' stocks and those that would be least capable of weathering a down economy or an all out recession. The market concludes that there must be some reason why these companies' prices have been discounted relative to the rest of the companies in the stock market. Once the lowest valuation companies have been sold off, investors move on to their biggest momentum holdings and sell them as well. Generally speaking, stocks with momentum typically maintain their value or even continue to climb slightly while the initial panic creates a selloff in value stocks (those with the lowest current valuations). Ultimately, everything and every stock price gets pulled down by the overwhelming force of the market until there is simply no one left willing to sell. This "capitulation" generally signifies the market bottom.
Once the bottom has been reached, and things begin to look rosier, the stocks with the lowest valuations (Value Stocks) tend to rebound the most and the fastest because again, they have the lowest valuations and represent companies that will likely do the best in a recovery or strong market environment. Value Stocks are kind of manic in that way, as they are the best performers in strong markets and the poorest performers when times get tough.
Once the recovery becomes old news, and things have stabilized with significantly reduced volatility and the overall mood of the market becomes consistently positive, stocks with momentum will again return to favor as every stock resumes its upward climb in price.
I'd like to point out that price discovery lessens while things are rosy in the stock market and everyone's focus turns to momentum. This is usually because with time, the pain of the prior downturn becomes a distant memory and investors gradually build up their confidence in their investing abilities and the market in general. As stress and volatility enter the markets, market participants return to price discovery to ensure their holdings are appropriately valued in order to minimize losses when the market turns less optimistic. This back and forth tug-of-war is always a significant part of the market's inner workings. There have been a number of academic studies that have concluded that the best way to build a factor-based portfolio is to find a balance between momentum and value factors (as well as others) and use them together for proper diversification. For example, one might find the one-hundred stocks with the highest momentum (12 month price change) in the stock market and then invest in the ten that have the lowest current valuation (using PE Ratio). To be clear, I am not suggesting this as an investment strategy, I am just using it to illustrate a method to use the momentum factor and value factor together.
Hopefully, from this post, you can see a little clearer how the market and its participants operate and how the language of factors is integral to understanding and investing in the stock market. In future posts, we'll dive deeper into additional concepts that further help us understand the stock market such as the wisdom versus madness of crowds and behavioral biases as well as whether or not the market can be beaten in general. Also, I intend to address the perpetual active versus passive investment management debate in a future post.
Please be so kind as to share any feedback, thoughts or questions as you read these posts.
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