What good are prices?

Photo: Peggy Marco. Source: Pixabay. CC0

Price theory tells us that all we need to set prices is supply and demand. The market price is the place where producers make just enough of something to meet consumers’ demand. The theory is applied to items as diverse as smartphones, flour, crude oil, and capital goods. When prices are rising, producers are supposed to provide more goods, and consumers cut back. When prices are falling, producers are supposed to cut back and consumers step up.

But how does this work in the stock market?

Stocks aren’t pieces of paper or bits on a screen. They’re fractional ownership in real companies providing real goods and services across the economy. That ownership represents a residual claim on the company’s cash flow, subject to the management’s decision on how best to deploy their free cash. When cash flow increases, that claim becomes more valuable and the price rises. When cash flow declines, prices fall.

This is why stock market investors don’t respond like consumers to price signals. When stock prices fall, they may indicate that something changed in the underlying investment. Or they may indicate nothing fundamental, there may simply be some large institutions reallocating their portfolios. Prices in the capital markets aren’t like the price of flour. Their prices sift a host of underlying information: revenue growth, operating costs, taxes, regulations, current and future interest rates, banking relationships. Sometimes rising prices mean the shares are getting is expensive and should be avoided; sometimes rising prices mean the outlook is looking up. When underlying fundamentals change, the hoard of investors trying to get in or out of an investment can act like a stampeding herd.

Photo: Dietmar Rabich. Source: Wikipedia. CC BY 4.0.

Equity prices can change without shares ever changing hands. New information can alter the underlying value. Several years ago, Dartmouth College admitted that they had unwittingly contaminated the groundwater near our home. Immediately, the market price for every piece of property in the neighborhood suddenly fell. No houses had changed hands, but their underlying value had been impacted by this new disclosure. The same thing can happen with stocks and bonds.

For the past decade, one of the most effective investment rules was to avoid the lowest-priced sectors of the market. In an era of technological disruption, financial repression, and political turmoil, low prices didn’t communicate that those shares were on sale. They told investors that something was wrong.

Comparative return of a portfolio with a simple rule: exclude the cheapest stocks. Source: Bloomberg and World Market Advisors. Note: taxes and rebalancing costs not included.

If we invested in the S&P 500 over the past decade and excluded the bottom tenth of shares (based on their forward price/earnings ratio), our portfolio returned almost 20% more than the index. This rule’s impact was remarkably consistent.

There have been lots and lots of talking heads telling us that the market is expensive, that stocks are in a bubble, that the flap over GameStop and Bitcoin and blank-check companies indicate that we are in the last stages of a speculative fervor that will put the dot-com mania to shame. Maybe. Just remember that it’s generally in the interest of the “stock shouters” to generate clicks, downloads, and forwards. Dramatic headlines are usually in their interest.

Friedrich Hayek noted that prices work in three ways: they distribute income, they provide incentives, and they communicate information. Prices are a gift from the market. It’s up to us to use the gift wisely and listen to what they’re saying.