So far in June, the stock market has continued to be volatile, but has gone nowhere since the end of May. Usually a stagnant period in the middle of a recovery would be disappointing, but in this case is more of a relief after a crummy May that saw a –8.3% drop in the S&P 500. In any case, mediocre market performance over the last month should not come as a surprise, given the amount of apparently bad news we have been receiving over the last few months about the progress of the recovery.
Investors often make the mistake of attributing current market performance to recent news. In reality, the stock market acts as a leading indicator for the economy. (For an explanation of economic indicators, see my last entry about the Volatility Index). News we hear on any given day is nearly always already reflected in current stock prices. (This concept is often called the “efficient market hypothesis.”) Exceptions include unforeseeable occurrences, such as the BP oil rig explosion, and events about which advance information is privy to only a select few individuals, such as the announcement of civil charges against Goldman Sachs. In nearly all other cases, so-called “current” information has already been considered by millions of investors, particularly professionals with huge amounts of capital, whose decisions move stock prices. On average, the stock market reflects information about five months in advance, so that today’s news is already 5 months old as far as the stock market is concerned.
Investment banks pay huge salaries and bonuses to analysts because they depend on them for recommendations that they use when making enormous bets on the market. Analysts are human like the rest of us, which means they can make mistakes and lack clairvoyance. But the combination of intelligence, experience, training and the resources at their disposal allows them, as a whole, to develop hypotheses about the future with a significant collectivedegree of success. This success comes from the sum of the incredible amount of manpower and money that professional investment firms devote to research.
Analysts are usually assigned to a specific sector or industry; some operate in the even narrower scope of analyzing a single security, or a select few. Many firms have multiple analysts working in each sector, which illustrates the amazing amount of resources dedicated to analyzing each area of the market (especially when you consider the inhuman hours that many analysts work). So it should come as no surprise that the European debt situation was being considered and accounted for months ago by large institutions—weeks or months before it was mentioned by the media. The same goes for financial reform, the anticipated slowdown in corporate earnings growth, and other economic issues that have recently induced fear (and selling) by day traders and non-professional investors.
Given their level of compensation and resources at their disposal, you can understand why analysts and their firms are expected to remain ahead of the curve and be right more often than not. However, this informational “edge” is not, by itself, enough to ensure outsized success for Wall Street, and it also does not mean that non-institutional investors can’t compete. Rather, it tends to create a marketplace that rewards contrarian investors who don’t blindly follow the crowd. The best investors do not act on information as it becomes public, because they know this information is already priced into the market. They take the information a step further and figure out what sort of opportunities it might create in the future.
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