Information and Demand

source: Capitalideasonline 

Demand is driven by psychological forces unique to each trader. Information becomes merely the excuse to place the order.

On and on it goes, a 61/2-hour-a-day barter system initiated by investors whose interests, goals, limitations, access to news, and interpretation of events are as unique as fingerprints. Realistically, only 5 percent of the peo­ple buying and selling Exxon that day analyzed the company's prospects and placed a value on the company's shares. The remaining 95 percent used a tidbit of information as an excuse to act out a prevailing emotion or finan­cial need. None of this suggests efficiency, but a system that holds stock prices hostage to the ebb and flow of emotion. Supply and demand truly drive prices on a day-to-day basis. Demand is driven by psychological forces unique to each trader. Information becomes merely the excuse to place the order.

At its worst, this outcry system results in organized chaos, panic, and true price inefficiency. Witness what happened in 1997 to Maverick Tube, the St. Louis-based maker of piping for oil wells. Amid a feeding frenzy for oil-drilling companies, Maverick's stock rose from $6 to $50 in nine months, then dropped again to $10 by mid-1998 (see Figure 1 below). Yet the company's earnings and net worth didn't rise ninefold. Nor was the sub­sequent collapse in price justified by fundamentals. Can such volatility be reasonable, or rational? Can one company be worth $6 a share in January, $50 by September, and $10 just seven months later? Absolutely not. We can say that in retrospect Maverick was fairly valued somewhere between those extremes and should not have fluctuated as much as it did. If the public had rationally priced Maverick, the stock might have risen slowly from $5 to $25 and remained at the price level for the next year. Instead, the stock was tugged up and down due to greed, fear, irrationality, and shifting percep­tions of the company's prospects.

Was the market efficient in 1996 when Coca-Cola traded at 40 times earnings, even though the company's earnings were expected to grow at only 17 percent rates? If investors accepted Coke's valuation, then they should have questioned whether Microsoft was efficiently priced at only 40 times earnings when earnings were growing at 35 percent rates. Was the pricing of Chase Manhattan efficient when the stock dropped to $ 12-five times earnings-in 1991 out of panic selling, only to rise above $100 in1997? What was efficient about the 1993 feeding frenzy surrounding bank­rupt LTV Steel, when investors piled in and bid a nearly worthless company up to $3 a share? The shares traded so far beyond the company's intrinsic worth that LTV officials had to issue public statements warning people the shares had no value.

Did General Electric's intrinsic worth increase 150 percent in 1995 and 1996? Judging from the stock price, it did. But was GE's price rational? Only to an EMT adherent. General Electric's earnings rose by only 32 per­cent during that time, and its shareholder's equity rose by only 38 percent. Yet the stock increased at four times the rate the company increased in value. The only plausible explanation for GE's rally was that its stock was grossly undervalued prior to the rally and merely caught up to GE's earn­ings trend. But to acknowledge that fact is to acknowledge that GE's stock was inefficiently priced before 1995.

The classic example, of course, occurred in 1987. Was the stock mar­ket efficiently priced before, or after, the Oct. 19 crash? Did the intrinsic value of U.S. companies really drop 22 percent in six hours as the stock market suggested? Not at all. Nothing changed in corporate America that tragic day. The economy plodded along as normal, consumers went on their merry ways shopping at retail stores, and assembly line workers kept up their normal pace of production. What changed that day wife perceptions, perceptions that stocks had been unreasonably priced.”