Does the Stock Price Fully Reflect the News?

In our investment process, we often have to ask ourselves this question: Something bad has happened to a company or market; does the current price reflect the news?

In our investment process, we often have to ask ourselves this question: Something bad has happened to a company or market; does the current price reflect the news?

Years ago, when I was an undergraduate finance student, the Efficient Markets Hypothesis (“EMH”) was popular and taught at virtually every university. The debate wasn’t about whether it applied or not, but rather to what extent. I have summarized the three “forms” of the EMH below:

  • Weak Form: Stock prices reflect all historical information. This means that past prices give no predictive information as to future prices. The implication is that technical analysis, such as studying chart patterns, or the “support” and “resistance” levels you hear about in the media, are worthless.
  • Semi-Strong Form: Stock prices reflect all publicly available information.
  • Strong Form: Stock prices reflect all information, whether publicly available or private (i.e. insider). In a strong form world, there would be no such thing as insider trading. Why? It would not be profitable, since all information has already been reflected in the current stock price.

In my classes, pretty much everyone agreed that the weak form held, and that charts were worthless. The debate was between semi-strong and strong. At the time, my personal view was that reality was somewhere in between the two.

After the last two stock market crashes, many began questioning the EMH and whether it is valid at all. Today, high frequency traders make millions of trades per day based on computer models driven largely by past data. If the weak form of the EMH held, there would be no profit in this type of strategy. Now I believe there is another factor to the EMH: time. Markets are reasonably efficient in the long run however, prices may become disconnected from the underlying value of a company or market for a period of time.

Stock prices adjust almost instantaneously to news. Markets are forward-looking, meaning price changes really are about changes in future expectations. Company XYZ reports earnings ahead of consensus expectations, but the stock price falls. Why is that? Management may have adjusted future earnings guidance lower or just sounded more pessimistic about the next few quarters in the future. This causes market participants to adjust their expectations (and the price) downward.  Some companies have grown tired of this short-term focus and refuse to even give guidance regarding their earnings.

So is it priced in? The answer is sometimes. The art is in determining when this is the case and when the consensus is wrong. We address this by having a disciplined investment process focused on fundamental data and ignoring short-term noise. Our focus is on financially strong companies that are likely to have rising earnings and dividends over time. However, working with our clients to determine an appropriate asset allocation that suits their individual situation and having the discipline to stick to it is even more important to investment success.

Bill Hansen, CFA
President & Chief Investment Officer

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