Monday, July 31, 2006

Expectations vs Reality

The stock market moves on expectations, not on its actual performance. If the market expects Firm A to grow its earnings by 20% for the next 5 years, the stock will rally 100% in the next 5 weeks. It does not matter if Firm A can actually grow its earnings 100% after 5 years. Similarly, if the street expects Firm B to miss its forecast, Firm B's stock will not wait for the announcement and then plunge. It will plunge today.

Zooming out to the bigger picture, if everyone expects the Singapore IR (i.e. Integrated Resort, where you integrate treadmills with slot machines with massage chairs placed toilets maintained by elite toilet specialists) to be an extraordinary success. It does not necessarily need to be an extraordinary success 5 yrs down the road for money to pour in by the truckload. It only needs everyone to think that it is a success, and everything from real estate prices, to ERP, bus fare, taxi fare, to stock prices except salaries and banana prices will skyrocket.

I used earnings and the IR to explain this phenomenon, but it can apply to everything, from favourable regulation changes to M&A rumours. The stock moves on what the collective thinking of all the investors point towards to and not the actual scenario that will eventually play out. If one can understand this, it is easy to see that this phenomenon has two impact:

1) The market may be wrong, but since the actual scenario does not happen immediately, at the meantime, the market is right. Hence the saying "the market is always right".

2) The market may be right, but it will almost always overreact (e.g. factoring 5 yrs of earnings in 5 weeks) and the scenario is played out in a shorter time frame than expected.

In the long run, the market moves towards the actual scenario and the market corrects its past mistakes. Hence value investing, by trying to estimate the intrinsic value of the company, stands the test of time and the idiosyncracies of the market.

Post a Comment