Some time ago, a reader sent me a collection of essays by a strategist from a renowned asset manager. In one of these essays, the author tried to tackle a seemingly philosophical problem and observed that the price chart of stocks or a market index like the S&P 500 is not time invariant, i.e. one cannot reverse the chart in time and expect to see something like a real chart. The classic example is a market crash like the one in October 1987. The S&P500 that day dropped more than 20% in one day and then slowly recovered. If one would look at the chart in reverse, it would be a situation where the S&P500 slowly declines and then suddenly jumps more than 20% in one day. That doesn’t happen in real life.
Hi Joachim, I wonder if weighting contributes to the situation? A stock which is over valued will have a higher market capitalisation, and will have a higher number of samples contributing to the index. Meanwhile, companies trading below fair value will be under- counted (less of their stock will be included). The collapse of a bubble sees the index suddenly re-weighted from the frothy sector toward the broader economy.
I would think that if each stock is 'independently' being reviewed and 'objectively' be valued that the value should 'independent' and the errors generally cancel out so the the overall valuation of the index used, say S&P 500, should follow a normal distribution and be more likely than not close to the 'fair' or, maybe better, 'intrinsic' value at a given point in time. This does not preclude material over- or under-valuations but does follow that, all things considered, the market is 'fairly valued' on average.
Ingeniuos article. Thanks for the input. Can‘t wait until I read part II.
Hi Joachim, I wonder if weighting contributes to the situation? A stock which is over valued will have a higher market capitalisation, and will have a higher number of samples contributing to the index. Meanwhile, companies trading below fair value will be under- counted (less of their stock will be included). The collapse of a bubble sees the index suddenly re-weighted from the frothy sector toward the broader economy.
I would think that if each stock is 'independently' being reviewed and 'objectively' be valued that the value should 'independent' and the errors generally cancel out so the the overall valuation of the index used, say S&P 500, should follow a normal distribution and be more likely than not close to the 'fair' or, maybe better, 'intrinsic' value at a given point in time. This does not preclude material over- or under-valuations but does follow that, all things considered, the market is 'fairly valued' on average.