The Value of Information

In 2007 and 2008, the economic news “cycle” was relentlessly bad. Then, in 2009 and 2010, it was steadily improving. The news today is decidedly mixed, and the behavior of the financial markets reflects that uncertainty. Market participants don’t seem to know which way to go.
 
When the news is steady, the markets move steadily – up, down or sideways. This is true whether the news is good, bad or indifferent. All financial assets are valued by looking into the future. We estimate future receipts of cash, we decide how much confidence we have in those estimates and we decide how high or low a return we are owed in order to buy into that particular investment. The higher the amount of cash we figure to receive, and the more certain we are that we are correct in our estimate, the more we will pay for the investment. On the other hand, the lower the estimated future receipts, or the less confidence we have in those estimates, the less we will pay for the investment. And then there are all sorts of combinations in between.
 
This calculus is true of stocks and bonds and darn near anything else.
 
With this in mind, we should be skeptical of expecting to automatically profit from good news. If market participants expect good news, and they get it, stock prices will not generally move very much. The news is already “priced in” and serves only to confirm what investors already expected.
 
The concept of “pricing in” future information is an important one, as it affects our decisions about individual stocks. If you asked people which company is likely to grow faster over the next 10 years, Google or General Electric, I think the consensus would be Google. After all, it’s growing faster today, and the information technology revolution is far from over.
 
If the consensus among investors is that Google will grow faster than GE, does that simple fact make Google the more attractive stock? Intuitively, one would assume that a faster growing company is an easy choice over a slower growing company. However, it is not as straightforward as that.
 
If Google continues its fast growth rate, the stock will prove to have been fairly valued. If GE continues its more modest growth rate, its stock will also prove to have been fairly valued. At the end of 10 years, both stocks should have returned similar amounts to shareholders. During those 10 years, we might watch as Google consistently reports faster earnings growth than GE, yet the share prices could move in tandem. Owners of Google stock expect and demand rapid growth in order to make up for the premium they pay for the shares. Google must grow fast simply to keep the share price stable.
 
This pricing mechanism is what makes stock picking such a fiendishly difficult trade. In theory, all stocks are equally attractive at any given moment, despite having widely varying prospects for the future. Even though each company in the S&P 500 has different prospects for earnings and growth, those expectations are priced into the shares. The market pricing process is highly efficient, to use an economist’s term. Some economists believe that the market is “perfectly efficient”.
 
I went to graduate school in economics, and I no more believe in perfect efficiency than I believe in the Easter Bunny. I think the market is sometimes very nearly efficient. By and large, no single stock and no single market sector stands out as dramatically mis-priced. On most days, investors rationally incorporate future information into the prices of stocks.
 
You can think of a stock – or the entire market – as always perched on a fence, ready to topple over one way or the other. The tiniest breaths of unexpected news will move prices.
 
Only two things can cause changes in stock prices. Unanticipated news, or “new news”, can alter investors’ expectations for the future. Alternatively, investors can suddenly begin to interpret existing information differently; they begin to see the world in a new light even though it was there all the time. In my own experience, the latter condition holds more promise for profitable investment decisions.