How the stock market operates? (Part I)

Every significant price move of any individual common stock occurs because of a changed appraisals of that stock by the financial community. It should never be forgotten that an appraisal is a subjective matter. It has nothing necessarily to do with what is going on in the real world around us. Rather, it results from what the person doing the appraising believes is going on, no matter how far from the actual facts such a judgment may be.

The key point to note is this, any individual stock does not rise or fall at any particular moment in time because of what is actually happening or will happen to that company. It rises or falls according to the current consensus of the financial community as to what is happening and will happen regardless of how far off this consensus may be from what is really occuring or will occur.

Because of a financial community appraisal that is at variance with the facts, a stock might well sell for a considerable period for much more or much less than it is intrinsically worth. Furthermore, many segments of the financial community of a habit of playing "following the leader", particularly when that leader is one of the larger New York City banks.

This sometimes means that when an unrealitic appraisal of a stock is already causing it to sell well above what a proper recognition of the facts would justify, the stock may stay at this too high level for a long period of time. Actually, from this already too high a price, it may go even higher. These wide variations between the financial community's appraisal of the stock and the true set of conditions affecting it may last for several years.

However, there will come a time when the bubble bursts. When a stock has been selling too high because of unrealistic expectations, sooner or later a growing number of stockholders grow tired of waiting. Their selling soon more than exhausts the buying power of the small number of additional buyers who still have faith in the old appraisal. The stock then comes tumbling down. Sometimes, the new appraisal is quite realistic. However, this re-examination is frequently evolved under the emotional pressure of falling prices, the negative is over-emphasized, leading to under valuation. It may take quite some time for a more favorable image to supplant the existing one.

It is important to note that in several instances what has shifted was the emphasis not the facts. Though, the facts too can change. A clearer picture develops when an investor ascribes price and intrinsic value to 2 different dimensions. The former is based on perceptions and the latter is based on reality.

For the purposes of clarity, I would define intrinsic value to be the amount that is justified by current facts. The reason I did not choose the absolute future cashflows is because there will be circumstances by which are not even reasonably foreseeable even by the extremely skilled investor.

Under such defintions, both price and instrinsic values are dynamic in nature. Though both are not the equivalent of each other, both can influence each other in several profound and important ways. The characteristics of a business intrinsic value will very much depend on the nature of the underlying business itself. Whereas for the price, much more will be due to behavioral traits of shareholders. With this picture in mind, the investor will have a clearer idea of how the stock market operates.

Thus, from here, arises an old Graham key principle.You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. This principle effectively shows why regressing historical prices against an index does not produce any meaningful results. It is in direct conflict of the the traditional Capital Asset Pricing Model (CAPM).

This can be quite interesting philosophically, because if a huge amount of people is willing to pay $2 for a $1 bill for an extended period of time, does it make that $1 bill to be worth $2? Fuzzy logic but an important thought to hold.