Welcome to our first Editor's Opinion piece. Let's take a look at the concept of 'market efficiency' and apply it to our Covid-19 current economy.
'Market efficiency' is the idea that when new information is released about a company in the stock market, that information is immediately integrated into the company’s share value. If there exists new information about a company that should affect the company's share value, but the release of this information has not impacted the share value, then the market may be operating inefficiently. Financial markets are very often inefficient.
The below graph (thanks to TheFelderReport.com) shows the price-to-sales ratio - which compares a company's stock price to its sales or revenues - next to its % average revenue growth for the tech companies Amazon, Apple, Facebook and Google. Is it efficient that as % average revenue growth slows, the stock price continues to go up? It could be that there is market information integrated into the share value that is outside of revenue growth, or it could be that there is an inefficient market forming (here, in the shape of a 'tech bubble', which we look at later). Take a look at The Felder Report’s blog for some more bite-sized bubble information (linked at the end).
Spotting inefficiencies and investing in the share before the market corrects that company’s share value can lead to anomalous returns to investment. For example, if a company is in reality worth $100 per share but the market price is $90 per share, then investing in the company at $90 per share allows the investor to sell the shares at a $10 profit per share once the value is corrected. If you think a company is over-valued, you can short it on the stock market. Short-selling (if bath-tubbed Margot Robbie hasn't already sufficiently explained it to you in that film) is where an investor borrows shares from, e.g., a broker and sells them on the stock market. If he is correct - he will buy back those shares for a lower price once the market has corrected. So, he borrows shares worth $100. He then sells the shares for $100. He buys the shares back for $70 two years later. He made $30. Another one: I expect ABC t-shirts to lose value in a few years, so I do not wish to buy an ABC t-shirt. Instead, I borrow Sally's ABC t-shirt for 3 years. I then sell it for $100 (market value) to Ben. Because Ben is wearing it, Sally asks me to pay her $1 per year for the loan of the t-shirt. In 3 years, market value of an ABC an t-shirt is $50. I buy it back from Ben for $50 and return it to Sally, who is obliged to take it back from me under the loan agreement. I now have $50 minus $3 interest I already paid, making my profit $47. Imagine I had borrowed 10,000 t-shirts.
Back to stocks. When the investor returns the shares to the lender, he will end the borrowing contract. As mentioned, borrowing usually means that the investor has to make interest payments on the value of the shares. Although interest payments should eventually come out of profits, remember that the investor has to actually make the payments while he is shorting. If the investor is wrong and he cannot buy back the shares (that he is contractually obliged to return) for this lesser value, then he must purchase the shares and give them back on their increased value. An expensive mistake - plus interest.
The risk with either method is whether the market inefficiency is actually corrected, and how long the investor must wait for that correction to occur. The old adage being "markets can remain inefficient longer than you can remain solvent".
So, where there is consensus between the ‘real world’ value and the ‘market’ value of a share, there is an efficient market. An interesting sentence - how can a share 'really' be worth any value other than what the market tells us? Shouldn't the market be reasonable enough to make accurate valuations of the instruments that operate in it? If it did, we wouldn't be able to generate profits from spotting inefficiencies.
Irrational markets and bubbles.
‘Economics’ suggests rationality, efficiency and sensible outcomes. The economist Poole describes ‘homo economicus’ – ‘the economic man’ who goes about ‘his daily life with unimpeachable rationality, efficiency calculating ways to maximise his self-interest’. Is the average financial analyst an economic man? If he were, the stock market wouldn’t be able to generate returns outside of average growth. Investopaedia explains bubbles as an ‘economic cycle’. “Bubbles are where there is a rapid escalation of asset prices, followed by a contraction of those prices. There is a surge in asset prices that cannot be justified on the underlying fundamentals [value-providers] of the asset, and driven by exuberant market behaviour. When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate.” So, investors completely overvalue an asset (e.g. stocks in the technology industry) by irrationally buying into it when its actual value (in the tech example, cash flows) does not justify that investment, and when that investor interest in the asset dies, the bubble collapses. The only thing keeping the bubble alive is this investor interest, because the underlying asset is long dead.
A quick aside on growth stocks, value stocks and market efficiency.
Let’s start out this next part by quickly understanding what growth and value stocks are. Ken Little for thebalance.com explains that ‘growth’ investing is in stocks that are growing with potential for continued growth; ‘value’ investing is in stocks that the market has underpriced and have the potential for an increase when the market corrects the price. So, ‘growth’ investing can exist in an efficient market as new information about the positive upturn of a company is integrated into the share value as that company grows organically. Value investing relies on an inefficient market that produces ‘undervalued’ shares that will provide a return once corrected.
Back to the markets…
Rob Arnott spoke about market bubbles on this week’s “What Goes Up” for Bloomberg. He reminds us that “the market can be irrational longer than you can remain solvent”. Although of course some of the govt-issued stimulus will make its way into the capital markets, he says, and that may keep them sustained at a level. However, he continues, this doesn’t make actually make huge economic sense in the context of how severe the coronavirus downturn is – this supply and demand shock. Arnott is concerned that there is an ‘insane’ dispersion in valuation between growth and value stocks. The dispersion we saw in the 1990s is ‘there again’, he says. A quick technical aside: as the average difference in value for each stock becomes greater, the higher the measure of dispersion. Arnott tells us that the tech bubble formed over the 1990s saw growth become 9x more expensive than value, and it is now 11x.
Let’s take a look at The Felder Report on this tech bubble: “Just three stocks, Apple, Amazon and Microsoft, make up more than 16% of the S&P 500 Index and over a third of the Nasdaq 100 Index. Together they are now valued at nearly $5 trillion. That’s larger than the entire economy of Germany and roughly the size of the Japanese economy. What is really most astounding, though, is the aggregate valuation of these three behemoths relative to their free cash flow. Only at the peak of the Dotcom Mania have we see anything like it – which begs the question: ‘If that was a bubble, what’s this?’” If you didn’t catch the first part, to make up 16% of the S&P 500 Index and 1/3 of NASDAQ means that across these two indexes that seek to reflect the entire US economy, these three companies hold 16% and 33% value.
So, back to the shorting example above, this might be a method an investor would consider on Microsoft stocks. He'd have to borrow and sell Microsoft shares now (for me, 1st Aug at 5:53pm) for $205 USD a share, and commit to buying them back for market value in a few years, plus interest based on the (currently high) value of the shares. Shorting Microsoft is pretty daunting. Then again, so was shorting the housing market pre-2008. Are we currently living with an efficient market, or preparing for another tech bubble? It is immensely difficult to say, which is why you pay professionals big money to tell you. As a finance blogger, this is very much an opinion piece and not investment advice you should act upon. Those Felder Report stats make my palms sweaty, though, that’s all I can tell you for sure.
So, finance blogger, what did I learn?
We spoke about what it means to have an efficient market, how investors can profit from market inefficiencies, and the market inefficiency of the possible tech bubble that is rumoured to be forming in today's Covid-19 economy. For information on the bankruptcy bubble and investment in Covid-struck companies, check out our Fallen Angel blog coming out later this week.
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