The stock market is a supercomputer and the news is already in the price

In online financial discussions, there are bears and bulls, boomsters and doomsters.

The curse of investing debates is that the bear case often sounds smarter.

This has been particularly so during 2020 during which there has been no shortage of apocalyptic news.

For example, how can a global tracker be down only ~5% year to date when we’re in a global pandemic and slow-motion economic train-wreck?

The first point is that, if you are still watching The News, that’s an own-goal. The business model of The News relies on drama and fear. Just because it’s on The News, that doesn’t mean it’s true or representative.

It’s the other way round: the less representative something is, the more newsworthy it is. Dog bites man…yawn, boring. Man bites dog…now you’re talking. This is why, when I research a subject, I cut out the middleman and go direct to primary information sources.

The second point is that the stock market is not the economy. The stock market is made up of the big publicly traded corporations of the world: Big Tech, Big Capital and The Rise of The Machines. The stock market does not include the small, independent, local businesses. Last week one of my local gyms went bankrupt; another casualty of lockdown…not a problem for the stock market but a personal tragedy for the young family that ran it.

The third point is that all the news you are seeing happened in the past. It takes time for official economic data to be gathered, analysed and released so the data The News reports today reflects how the world was last month, last quarter or last year.

In contrast, the stock market is looking far, far out into the future. The value of any asset is the the present value of the future cashflows that will accrue to the owner of that asset. Most of the value of a company usually sits in the cashflows beyond the next 5 – 10 years.

The “correct” share price is today’s value of the future cash flows to be received by the shareholder. A simple way to think about this is consider the dividends paid on shares.

If the annual dividend yield is 2% then it takes you 50 years to get your purchase price back (assuming no sale and no dividend increase). With dividend growth, that duration changes but you get the point. People often say things like “the City is short-term” but the market is actually looking years and decades ahead.

The stock market is like a gigantic supercomputer that gathers information, reflects uncertainty, weighs up all the bets placed and produces prices that reflect that information and uncertainty. In the jargon, the stockmarket is “efficient”. That means it reflects the available information and uncertainty well enough that you can’t beat the market by reading newspapers, broker research or listening to your mate Dave down the pub.

So how good is that supercomputer? How good is the market at pricing the zillion pieces of information, picking out what’s important and discarding the noise? Well, given the impossible scale of the task, the supercomputer is REALLY, REALLY good at it.

This is not to sat that the market is always right. Working in corporate finance, I got a ringside seat to watch several market bubbles where the market got it wrong.

When I started out the Japanese stockmarket was climbing down from an insane 80x price : earnings ratio. That was followed by a biotech bubble, a football club bubble, the late 90s tech bubble, the housing credit and sub-prime bubbles, the commodities supercycle (what happened to that?) and another gold bubble.

So the stock market is not 100% efficient. It is not some all-powerful god. But it’s got far more processing power than any one person (or one team of people). We know it gives strange results from time to time, but we can only know if it was wrong for sure later: after the bubble is over and The Fat Lady Has Sung.

The supercomputer is much better at handling uncertainty than we are. I don’t think that we humans are wired to naturally understand the concepts of discounting a future that has an infinite range of future possibilities. People often think in binary terms: things get labelled “good” or “bad”. People are terrible at thinking in nuance, probabilities and second order consequences.

This is what Howard Marks calls “Level One Thinking” where people see something obvious but don’t consider the knock-on effects or the reactions of other players in the game.

What is second-level thinking?

First level thinking says, “It’s a good company, let’s buy the stock.” Second level thinking says “It’s a good company but everyone thinks its a great company and its not. So the stock’s overated and overpriced; let’s sell”.

First-level thinking says “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says “The outlook stinks, but everyone else is selling in panic. Buy!”

First-level thinking says “I think the company’s earnings will fall; sell” Second-level thinking says “I think the company’s earnings will fall less than people expect and the pleasant surprise will lift the stockmarket.

The Most Important Thing – Howard Marks

One of the things that confuses rookie investors is that they see stockmarket prices often going UP on bad news and DOWN on good news. How can that be?

The News is useless for investment predictions because a) much of it is exaggerated or misleading b) nobody knows what’s going to happen in the future and c) even if you knew the timing of big future global events you still wouldn’t be able to reliably play the market correctly because of the way that the stock market is already “pricing in” future probabilities and possibilities.

A useful concept here is the idea of The Expectations Treadmill.

Imagine that Amazon as a pro athlete running on one of those treadmill machines that you see in most gyms.

With the amazing past performance of Amazon, the expectations of the market are high and the speed of its treadmill is set to FAST.

So Amazon has to run hard just to keep up with expectations. It only takes one small stumble for Amazon to fail to keep up with the treadmill and the price to fall sharply.

Now imagine an under-performing and unfit company walks over to the same treadmill. The analysts and investors set the speed low based on what they’ve seen of them in the past. The conveyor belt moves so slowly that it isn’t that hard for our overweight company to keep up and even outperform the treadmill.

That’s your value stock. He may not look good, but in the short term, he’s just as likely to outperform Amazon. Over the short term its basically a coinflip as to which does better.

So the stock market is a supercomputer that aggregates knowledge from millions of sources and updates in real time. Prices are are formed by millions of people with different information and opinions. All have skin in the game; they are backing those opinions up with real money: people’s hard-earned savings. By investing in a global equities tracker fund, you can “piggy-back” off the power of this supercomputer.

What if you want to try to maximise returns and beat the competition? Well, there are 3 sources of potential competitive advantage (known as edge) when investing in the stock market.

The first is to out-work the competition. This is the route attempted by most professional fund managers who get up earlier in the morning, stay up later at night, read more reports, got to more meetings, send more emails and have more heart attacks. It’s hard to outwork a supercomputer. So for those of us that want an easy life, this is not a very promising avenue of exploration.

The second is to out-think the competition. The Buffetts & Mungers of this world read widely, think deeply and put their money where their mouth (or should that be mind?) is. This is risky and difficult; there is a blurred line between genius and insanity. Being early is hard to distinguish from being wrong and it’s really hard to resist group think. So this is another unpromising avenue of exploration.

The third approach is to control our emotions, think long term, keep calm and carry on. This involves knowing our limitations and controlling our ego. Our internal demons are pride, fear, greed, exuberance and anxiety. If you can control these, you will get better results than 99% of people.

You can do this and pick individual stocks but it’s a LOT safer and easier to power your compounding machine with a low cost global equity index tracker.


6 comments

  1. skin in the game is key for accountability. we put out two stock series. the first is our own stock holdings each month versus a tracker. the second, the malevolent missy series, follows a newer investor who buys and equal amount of one stock per month and the same amount of 2 popular trackers. we own all of the missy stock and bought them with our own hard earned money. we also try to explain our thinking in building a growth stock portfolio this way. in the end it’s very transparent because the data are all public and they don’t lie. cheers.

  2. What is even worse is that there is a whole industry in “pump and dump”.
    They lure in naive “investors” and take their money – an obvious example is the Sunday papers “stock of the week” but in he age where all.information is online there’s so much more deception that’s going on.

    With the gyrations of the stock market these days I get the image of small.investors being a shoal of fish – moving this way and that in a shimmering display of coordination – market up 3% one day on good news and down 5% on bad news.
    All the while the sharks are eating alive any fry that swims too fast, slow, turns to early or.turns too late.

    I now.believe that you can make.money from the stocks but not the market.

  3. […] TEA breaks down the efficient markets theorem for our times (24) […]

  4. Just do the exact opposite of the crowd and you’ll be right more often than not, in life and in investing. Is my belief anyway.

  5. Great article, never a bad thing to go over the facts of (investing) life.
    Can you share how you find authoritative sources for day to day news? BBC seems to have sunk to a new during COVID and I struggle to find sensible updates

  6. The news just seems to cause me anxiety for many reasons. It’s better to step away as you lose nothing and get to keep your sanity.

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