strategically inefficient…

Any student of Wall Street, or any other world stock market for that matter, knows that investors periodically fall under the sway of manias or panics.  In my professional life, I’ve lived through–among others–the mania for oil stocks in the early Eighties, for Japanese stocks in the late Eighties, for Asian stocks in the early Nineties, the Internet bubble of the late Nineties and the run-up to the recent meltdown of financial stocks, during which period commercial and investment banks could do no wrong.

In the aftermath of these episodes, markets can become quite depressed.  Occasionally, as in early 2003 and early 2009, stocks can temporarily fall so far in price that the dividend yield on the stock market of a country exceeds the coupon on its government debt.  Inevitably, a sharp rally follows.

Another way describing this behavior pattern is that in a strategic sense stock markets are very inefficient.  Investors have very little consciousness of the forest.

—but tactically efficient

On the other hand, in my experience, stock markets have always been very tactically efficient.  That is to say, publicly available information about specific companies is either anticipated by investors prior to public announcement–from, say, the results of private surveys or by inference from industry data–or at the very least, very quickly incorporated into stock prices.  In the Eighties, for example, Kyocera was the sole source for ceramic casings that Intel used to hold its newest microprocessor chips.  Kyocera’s production plans were publicly available in Japan.  So analysts soon learned to give a call to Kyocera’s investor relations department to find out this valuable leading indicator.  More recently, during the iPod boom, one could get a good handle on Apple’s production plans by looking at orders for the micro-motors that turned the small form factor hard disk drives that every iPod contained.  iPods were virtually the only users of these tiny drives, which were made almost entirely by a single company, Nidec.  No need to call Japan; Nidec had a New York investor relations office.

what about now?

I’m not sure I want to make a strong claim for Wall Street’s tactical efficiency any more.  Three recent occurrences that have really stock out to me:

–Fed Chairman Bernanke recently gave congressional testimony that caused Wall Street to drop sharply as it heard his words.  But he was just repeating what had been said in the minutes of the Fed’s Open Market Committee meeting, which had been released the week before.

–The New York Times Company reported results last week (I wrote briefly about this on July 23).  The company said that ad revenues were basically flat–for the first time in a long while–because online ad growth was big enough to offset the decline in print advertising.  Two days later, after this was flagged in the newspapers and by news services online, the stock reacted by rising 4% or so.

–In mid-June, FedEx was the first of a series of transportation companies to announce that its international business was booming.  It felt good enough about its prospects to begin restoring employee compensation cut during the downturn (I also wrote about this, on June 20).  The stock went down on the news–and stayed down amid a series of similar bullish announcements by other transport firms.  It rose sharply yesterday when it said (surprise, surprise) that the trends it spoke of in June were continuing in July.  As a result, near-term earnings would be higher than FDX’s original guidance.

why no discounting?

First of all, it may be that these are anomalous incidents.  It’s possible that what I see as the market not discounting important information is actually the discounting mechanism working in a much more sophisticated way than I perceive.  I don’t think so, but I’ve got to keep this in mind.

I think two factors are at work:

–large-scale layoffs of veteran researchers by investment banks has reduced the quality and quantity of research output by the sell side.  The same is likely true, to a lesser extent, of the buy side.

–the absence of individual investors in the stock market, either through direct stock purchases or through investment in actively managed mutual funds.  Computer-driven trading, an important factor in market movements since the Eighties, may have lost part of the counterbalance provided by stock-picking activity.

conclusions?

If my perceptions are right, the risk character of individual stock selection may be changing.  The rewards may be greater, but their timing may be less predictable.  The biggest practical result may be that you will either be way ahead of the market in buying a stock (and may need a lot of patience) or way behind it (and be playing an idea that’s long since discounted in today’s price).  More on this topic in later posts.