theories of stock market

this is a chapter from my book the art of speculation

Theories of stock market

The firm foundation theory

The castle in the air theory

And the random walk model

All these theories have been discussed and debated and have been lade threadbare in various books and papers each have their own proponents and critics each theory substantiates a certain view point of the market

Let’s look at them

The firm foundation theory says that the value of stocks is rooted in some in some fair value that is that a stock has certain basic value which can be concluded from its sales earnings and other multiplies  this theory supports the fundamental analysis and  is rooted deep in the financial markets .

Various books and writers have propounded this theory and this is the bedrock of today’s financial market or equity analysts job this theory rests on the basic principle that earnings and sales can be extrapolated into future   and by discounting the present rate of growth future prices of share can be found and also the present price can be compared can be decided that whether a stock is cheap or dear.

Various financial parameters are included in this one commonly used parameter is the price to earning ratio which determines the correlation between the earning and the price that the market is willing to pay for that earning.

A company can be cheap or dear depending on the PE ratio that is prevalent for the sector as a whole high growth industries have high pe ratios and low growth have low PE ratios so a simple strategy would be to buy stocks that have low PE ratio compared to their peers and than they are bound to show you good returns

So an equity analyst takes into account all these factors and decided whether to make a investment or not this theory believes that even if stock prices go ashtray in the long run they will revert to their fair price and that the basic believe that this theory works on

But this theory has several holes firstly is you asked 10 analysts to give you an earning estimate 10 will give you different versions of the same and then too those would be very far off from the original

Also its very difficult to predict the future earnings of company and come to conclusion of the fair price of share bade on that companies can have drastic changes in their earnings depending on the market conditions and the initial guess can be way off the mark

Also the market adjusts PE ratios and other financial parameters very fast in a downward market the PE ratios of an entire sector can be adjusted very fast and entire investment can go drastically hay wire

the firm foetation theory is the bedrock of investing in the financial world it is very difficult to discount it because it seems like logical answer to an otherwise illogical behaviour of the stock market but to believe that stock market that is made up of millions of people behaving in an irrational manner would somehow keep in mind what is the fair price of share seems like an outstretched idea.

this theory though having substantial following has never been proven and it has never been proven that all the equity analysts with all their tools can provide a better return various studies conducted have shown that someone throwing a dart the stocks would have been better off in the stock market than taking the advice of the equity analyst

but since this is what the financial world believes in this theory has enormous power if big institutions and manages arrive at the fair values than this group of people with their enormous power can drive down or up the price of share because all of them sail in the same boat they have the same idea and they have enormous power in terms of the finances that they control

it’s like a  closed club where entry is restricted to only those who speak the language that is considered to be the language of the  elite and fundamental analysis is the jargon this elite club which separates them from others whether it has any relevance or not is not important what is important that how many people believe in that and since the financial experts need an esoteric and understandable language to separate them from others all the financial ratios and the gibberish which cannot be understood by a common man is their tool of differentiation and the reason for commanding high salaries which has no basis

The castle in the air theory

the castle in the air theory states that it all right to pay price for a particular stock till there is another fool who is willing to pay you an even higher price .this theory believes that stock prices are decided by people and it has got no relevance to the fundamentals of the company all that there is know about the company is reflected in its stock price and that the golden rule on which this theory is based.

this theory is held by the technical analyst people who look at charts volume action and then decide that whether stock should go up or down they believe in trends that if a stock is going yup it would resume it uptrend and if a stock is going down it would resume it downtrend and this and proponents of this theory believe that then chart is supreme and it tells everything that is there to know.

Various studies conducted have shown that the price of stock had got no correlation to what was the price the previous day and all the patterns that chartists talk about can be seen everywhere for example if you draw chart of coin being flipped you would find the same patterns in the chart as you would find in stock chart

Charting theory has so many holes that it is difficult to count them and also it is difficult to find any substantial basis that proves the chartists right

chartists have been there since a very long time but they were never given any respect but with advent of information technology and data it is now possible for everybody to have access to charts somehow this easiness of charting has bought new life to the charting community everybody is chartists and they are given prominent coverage but the fact remains that technical analysis is all hogwash

the only reason that brokerages and channels employ these people because for channels they talk in language that makes what channels do live coverage and their own show of understanding possible and for brokerages it is way to churn your portfolio more often and this what makes them commissions which is t life blood of a brokerage business .

so the castle in air theory has many loopholes and charting is something on which voluminous data has been written but charting just does not take into account that every day is new day it h stock market, market is reacting to many factors and the factors can change overnight and even in intraday so it futile to think that market has got a trend a market has a trend so long as the factors supporting that trend remain in place and as soon as those factors change so if you buying at higher and higher price and selling at lower and lower price the losses can be substantial 

So I would advise that that let go of the technical analysis

The random walk model

Of all the theories the random walk model makes the most sense it says that it is difficult to predict the market and that every move is different from the previous moves the only way to succeeds is to be able predict these moves and this model is the most apt to what a stock market is

Market is random and the market irrational market reacts to news and when markets react to news they do so in an extreme fashion both on an uptrend as well on an downtrend

So trading in the stock market is like taking random walk it can go anywhere and can lead you also anywhere and this is best explanation that someone can get of a stock market all the other theories which try to confine markets in some parameters be it fundamental and technical go against the basic nature of the stock market