The Stock Market Is Smarter Than You Think

The stock market’s volatility and the erratic pricing of some companies’ shares have raised questions about whether stock prices are linked to economic fundamentals. Some specialists even assert that stock markets lead lives of their own. Nobel Prize winner Robert Shiller writes, “Fundamentally, stock markets are driven by popular narratives, which don’t need basis in solid facts.”

1 Bill Gross, co-founder, and former chief investment officer of PIMCO, one of the world’s largest fixed-income investment managers, claims that the last 100 years of U.S. stock returns “belied a commonsensical flaw much like that of a chain letter or yes—a Ponzi scheme.”

2 Does it make sense to view the stock market as an arena where sensations rule supreme? We think not. Certainly, irrational behavior can drive prices for some stocks in some sectors in the short term. And for shorter periods, even the market as a whole can lose touch with economic fundamentals. But in the long term, the facts clearly show that individual stocks and the market as a whole track return on invested capital (ROIC) and growth.

For this reason, managers should continue to make decisions based on these fundamental value drivers. By doing so, managers can also detect and perhaps exploit any irrational market deviations if and when they occur.

we’ll explain how a market with different types of investors can lead to rational prices most of the time, even if some of the investors don’t make decisions based on economic fundamentals. Then we’ll show the empirical evidence that growth and ROIC are, in fact, the key drivers of value. Finally, we’ll explore the myths behind many commonly accepted beliefs that are at odds with the fundamental principles of valuation

MARKETS AND FUNDAMENTALS: A MODEL

We use a straightforward model to illustrate how market trading by both fundamental, or informed, investors and nonfundamental investors (what we call “noise traders”) will produce prices that are generally in line with intrinsic value but can still be volatile. 3 These prices may even deviate significantly from intrinsic value under certain, albeit rare, conditions.

Assume a basic market where trading is limited to only one company’s stock and a risk-free asset (for comparison). Two types of investors trade in this market. Informed investors develop a point of view about the intrinsic value of the company’s shares based on its underlying fundamentals, such as return on capital and growth. They base their buy and sell decisions on this informed point of view. They may not all agree on the intrinsic value. Some may believe the company’s shares are worth $40, others $50, and others $60.
Because of transaction costs and uncertainty about the intrinsic value, they will trade only if the stock price deviates by more than 10 percent from their value estimates.