When we talk about the way we invest you might hear us saying we believe prices are fair; that we believe in the power of markets; or that we believe there is information in stock market prices. These are different ways of saying largely the same thing—that we believe the market does a good job of incorporating information into prices.
For example, when a company reports its quarterly results to the market, there is often a near-instantaneous change in price as the market reassesses how the new information changes the company’s future earning capability.
To understand more deeply what is going on in the stock market we can think of how another market, the market for bets on English Premier League, operated this season.
You will undoubtedly have heard that Leicester City won the league, a remarkable feat considering they were close to relegation last season and started this season with some bookmakers offering odds of 5000-1 on them becoming champions. Bookmakers considered the event as likely as finding Elvis alive, with an implied probability of 0.02% (zero). One cheeky bookmaker scrawled “pigs might fly” on an optimistic punter’s betting slip.
As the season progressed, however, bookmakers quickly revised their odds every time new price-sensitive information came to light. That new information reflected not only Leicester’s (sometimes unlikely) results but also the results of their title challengers, which of course had significant effect on Leicester’s chances. By Christmas, the odds had fallen to 10-1 and by mid-March they were 10/11 odds-on favourites.
Stock Market prices are forward-looking in the same way betting odds are an expression of the likelihood of a future event occurring. Throughout the season, bookmakers were pricing and repricing their expectation of Leicester lifting the trophy in the same way a market does when it collectively arrives at a security’s price. Company results, competitor’s results and a seemingly infinite number of other outside influences combine to set expectations of future security returns.
Click this link for more information on market efficiency and stock prices.