Understand the stock market with this comprehensive guide on why analyzing securities is essential for any investor. Dive into the different analysis techniques and make informed investment decisions.
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Wall Street has tons of analysts, strategists, and portfolio managers hired to do one thing: beat the market. Analysts are hired to find undervalued stocks. Strategists are hired to predict the direction of the market and various sectors. Portfolio managers are hired to put it all together and outperform their benchmark, usually the S&P 500 index. Granted, there are many studies and disputes raging on the performance of equity mutual funds, but it's safe to assume that about 75% of equity mutual funds underperform the S&P 500. With these kinds of stats, wouldn't individual investors be better off simply investing in an index fund rather than attempting to beat the market?
There are different ways to analyze the market. The added value of analysis is in the eye of the beholder:
A believes that analyzing strategy, management, product, financial statistics, and many other readily and not-so-readily quantifiable numbers will help choose stocks that will outperform the market. They are also likely to believe that there's little-to-no value in analyzing past prices and that technical analysts would be better off stargazing.
The believes that the chart, volume, momentum, and an array of mathematical indicators hold the keys to superior performance. Technicians are just as likely to believe that fundamental data is complete hogwash.
And then there are the who believe that any attempt to try and outwit the market is futile.
So whom do you believe? Is fundamental analysis worth the time and effort? Are technicians a bunch of quacks? Or is it all a lesson in random futility? We can begin to answer these questions by looking at the efficient market hypothesis and seeing where the fundamentalists, technicians, and random walkers stand regarding market efficiency. After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis, and technical analysis.
The debate concerning the value of analysis begins with the question of market efficiency. What does the price of a stock or security represent? Is a security's current price an accurate reflection of its fair value? Do anomalies exist that allow traders and investors the opportunity to beat the market by finding undervalued or overvalued securities?
There are different definitions of an efficient market. Aswath Damodaran, of the Stern Business School at New York University defines an efficient market as one in which the market price is an unbiased estimate of the true value of the investment. That's true, but it's also an oversimplification. In an efficient market, the current security price fully reflects all available information and is the fair value.
In this ideal scenario, the price is the sum value of all views (bullish, bearish, or otherwise) held by market participants. As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling). So, the price is the fair value because the market agreed on a price to buy and sell the security. In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random. Over the long run, the price should accurately reflect fair value.
The hypothesis also asserts that if markets are efficient, then it should be virtually impossible to outperform the market on a sustained basis. Even though deviations will occur and there will be periods when securities are overvalued or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them.
From experience, most investors would agree that the market isn't perfectly efficient: anomalies exist, and some investors and traders outperform the market. There are varying degrees of market efficiency which have been broken down into three levels. These three levels also happen to correspond to the beliefs of fundamentalists, technicians, and random walkers.
The Strong Form of market efficiency theorizes that the current price reflects all information available. It doesn't matter if this information is available to the public or privy to top management; if it exists, it's reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are Strong Form efficient and all information is reflected in the price.
The Semi-Strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements, and other relevant information that can be readily gathered. Yet, all information isn't readily available to the public which means that all information isn't fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers, or regulators, among others. Anomalies exist when information is withheld from the public, and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously, making it virtually impossible to profit from such news. The Random Walk theory is an example of the Semi-Strong Form of market efficiency.
The Weak Form of market efficiency theorizes that the current price doesn't reflect the fair value and is only a reflection of past prices. In addition, the future price can't be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of Weak Form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value; these models will help identify anomalies.
Many in academia believe that security prices are semi-strong efficient. Recall that "semi-strong efficient" implies that all public knowledge is reflected in the price, and it's virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price.
Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster and new developments are factored in instantly. A surprise, positive or negative, can violently move the price of a security. A few examples include:
After announcing weak guidance during its earnings call on February 9, 2023 (after the close), Lyft shares fell from $16.22 to close at $10.31 the following trading day.
Even though NVDA reported slightly higher revenue and net income in their Q4 earnings report on February 22, 2023, strong guidance saw NVDA stock gap up from $207.50 to close at $236.60 the following trading day.
These are just a few examples but they demonstrate how new information can move the price of a security in non-random ways.
