Friday, December 20, 2013

The gravity of the market

The market is nothing more than millions of individuals making millions of decisions at the same time.  Yet through these millions of decisions consensus forms and stocks slowly rise or decline towards their fair value.  This idea that stocks are pulled towards their fair value is what I term the gravity of the market.

I view the stock market as a spectrum of value, from zero value on one side to outrageously valued (think snapchat) on the other side.  Every traded company falls on this spectrum somewhere, and often the company's position changes hourly, daily, and yearly.  I envision my spectrum in two ways.  The first is that there is a center of gravity to the spectrum, when there are a relatively equal number of undervalued and overvalued stocks the market is in balance.  When undervalued stocks prevail the market is out of balance and is due to tip higher.  Conversely when there are too many overvalued companies, and not as many undervalued companies the market is out of balance and is due to tip lower.

The second way I visualize my spectrum is I imagine it having a mass of gravity that is constantly working to pull companies towards the center.  The market doesn't like companies that are out of balance, it is always pulling towards the center.  The force of market gravity is much stronger at the edges.  A company hovering near the center might be slightly undervalued, but the pull of gravity near the center is so weak the stock might never be pulled the last little bit.  On the other hand a company at either edge of the spectrum feels the pull of the market's gravity very strongly.  A small improvement for an undervalued company could translate into a giant advance towards the center.  A small slip-up for an overvalued company could mark a quick retreat towards the center.

I don't think many investors would dispute my theory of market gravity, it's essentially a different way of thinking about reversion to the mean.  I prefer the idea of gravity because it's a strong force, mean reversion doesn't carry as strong of a connotation.

The issue many investors have is they find the idea of market gravity mysterious, and mysterious unexplainable things are hard to accept.  I don't find the idea mysterious at all.  There are millions of investors trawling through securities worldwide.  No security is unknown, although many might only be known to a small group of people.  The process of investors looking for, talking about, and investing in stocks moves these companies towards the center of gravity.  At times it might seem like an investor buying 100 shares of a tiny pink sheet company is meaningless, but even small actions matter.  The 100 share investor might tell a friend, or email about a stock and 10,000 share investor might become interested and slightly move the price.

By nature investors can't hold back on talking about bargains they've found, they're inclined to share their ideas with friends.  Get more than two investors together and suddenly ideas will be flowing.  Likewise there is a jumpy or jittery nature to investors who invest in overvalued companies.  Many times investors will recognize they're playing with fire and are hoping to get out just before the bottom falls out of a hot stock.  Enough investors looking to avoid a dip might result in exaggerated moves with a high flying stock.

The force of the market's gravity is strong and I don't believe it's failed yet.  There is no list of stocks that have always traded at lofty valuations, and there is no list of stocks that have traded at 15% of book value forever.  Both situations are corrected eventually.

Many investors don't have the patience to wait for gravity to pull their holdings towards fair value.  Instead of believing in the force and being patient they seek out catalysts, investors who by sheer will attempt to overpower the market's gravity and push stocks to fair value themselves.  At times a catalyst can work, other times it's nothing more than a hope or a dream.

I have generally found that finding stocks on the far edge of the undervalued spectrum combined with a heavy dose of patience has resulted in satisfying returns.  Once I purchase I sit back and let the market's gravity do its work.  The question is do you believe in the force of the market's gravity?  And does your investing reflect this belief, or lack thereof?

12 comments:

  1. I think that describing this force as gravity isn't painting the right picture. Gravity gets stronger while you get closer, while mean reversion gets weaker. It's a good thing that stocks can't reach escape velocity :)

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    1. The geeky physicist in me thought the same thing.

      Also gravity is an extremely weak force. Hopefully that part doesn't hold true for us value investors :p

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    2. Interesting to have the scientists chime in. I will readily admit my exposure to physics was the college class people called "physics for poets". The name alone should give a hint at how rigorous the class was.

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    3. It's more like a coiled spring or rubber band - the force is proportional to the distance.

      http://en.wikipedia.org/wiki/Hooke%27s_law

      I wonder what the average elastic modulus is for stocks.

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  2. I like your description of price discovery, but I also have a problem with the concept of gravity as a metaphor here.

    Really, what you're describing is more like a charged sphere with some sort of responsive particles in it. As they approach the sides they are repelled back towards the centre, with the force depreciating in potency as they head towards it.

    Most of them bob around in the middle, but occasionally one is bashed out to the fringes. As per your thought experiment, the force is stronger at the edges, and it will soon be repelled back towards the centre.

    The problem with both metaphors (as you know, and I appreciate this is just a thought experiment -- but I'm running with it! :) ) is that physical laws are analog and consistent, whereas the stock market is inconsistent. An apple will fall immediately on being released from my hand, but a low price-to-book stock can stay that way for years, or for ten minutes.

    Perhaps we need to turn to quantum mechanics at this point...? ;)

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    1. I responded to an earlier comment that my physics background was essentially limited to a physics fluff class I took in college. Quantum mechanics, charged spheres, particles..to steal a term, those things are out of my "circle of competence."

      You're right though that the laws of physics are constant and the market is chaotic at best. I guess for all those physics-heads my analogy breaks down. It made sense to me at least!

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    2. It makes sense to me too!Despite some imperfections from the physics point of view I do like your gravity analogy: it's intuitive and simple.

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  3. Now that the pedantic comments are aside - it's a great analogy! Maybe I think so because it's how I think of it as well...

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    1. Undervaluation tends to be followed by overvaluation,and vice-versa.Rarely does it stop at fair market value.

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  4. Don't forget that intrinsic value can change against you, and reversion can take too long. I think more people need to view the market as mysterious, it's scary how much money is gambled as "investments".

    Thanks for the great blog!

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  5. Amazon has almost always traded at a lofty value. I am still waiting for that big correction to happen...

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