In Defense of the Wisdom of Markets

We often hear that markets are over-pricing one asset and under-pricing some other asset. You will hear analysts use the terms “fair price” or “fundamental value.” Some people will say that markets are irrational.

This happens all the time. I most often hear it in regards to Apple: Many say Apple is a gimmick, simply a brilliant marketer. On the other hand, many say that the market actually punishes Apple's stock, noting that it trades much lower than its peers relative to its huge earnings. Horace Dediu recently made the case that the market punishes Apple because it doesn’t understand innovation, and innovation is what Apple is all about.

It’s not just Apple, of course. Recently, an NYU finance professor made headlines for claiming that Tesla’s stock price is grossly over-valued and that the most optimistic price he can arrive at is 60% below where it currently trades. Matt Yglesias has a great response.

You can find countless other examples on your own by reading news articles in any business section on any given day. But is any of this really the case? Does such a concept of under-valued or over-valued make sense? How does one know the true price of anything?

But what if we take a different view. What if we try to approach the market as something that is meant to be interpreted, not judged or predicted. But more on that in a second.

First, notice how we talk about the market: we talk about it as a person with opinions, beliefs, even feelings. And this really is the case! The market’s opinions and beliefs are simply an aggregation of individual opinions and beliefs. Because investors choose the size of their bets, those beliefs are weighted by how strongly investors believe them (and of course, their access to capital, but never mind that). As such, we really can talk about the market as having an opinion. The hard part is interpreting this opinion.

And so what do we mean when we say that the market is under or over-pricing something? Under or over what? You might say the true price. I say what is the true price? You say the true price is the price that is consistent with the fundamental value of the company. I say how do we know that value? We go in circles.

Now let's take a different view. What if instead of saying that Tesla’s stock price is too high, we say that your estimated price is too low? After all, isn’t the market price the most consensus estimate, and so shouldn’t the market price be used as the point of reference? This is not simply a restatement of the efficient market hypothesis -- I am trying to change the way you think about what the market price means. The market price is the true price. That doesn’t mean your estimate is wrong -- it also doesn’t mean the market is right. It just means that you and the market disagree.

Why do you and the market disagree so much? Ah, well now you’ve got a question worth exploring.

Matt Yglesias already discusses what the market might be saying about Tesla.

When it comes to Apple and its punished stock price, is it possible that the market is simply discounting Apple's value because it believes innovation is so unpredictable, even for a company with such a stellar reputation of innovation such as Apple? That is, might it be that the market believes past innovation is not at all a good predictor of future innovation? And maybe that really is the case -- maybe innovation really is random, even at Apple.

Even if innovation isn’t random, suppose the market believes it anyway and that that is why it is discounting Apple's stock price so much. Does such a belief in the unpredictability of innovation mean that the market is inefficient? Does it mean that the market is irrational?

My own advice is to be very careful when you bet against the market opinion. The market is truly very wise. It is not perfect, just like the humans it draws its wisdom from, but it is the consensus of real people using real money to make real bets on the future. It is much better at predicting the future than any forecaster or analyst I have ever come across.

Two thousand years ago, the market would have predicted that the world is flat. If your first reaction to that is see the market was wrong!, then you’re not thinking about it properly. The question you should be asking is: given everything that was known two thousand years ago, what was the best guess of the shape of the earth?