In case you still thought markets were efficient…

May 30, 2012
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I love this Barry Ritholtz quote, re, Facebook:

The ongoing decline in Facebook stock is little more than a reassessment of the private market’s valuation — now recognized as somewhere between wildly optimistic and clinically insane.

Cooler heads are now giving Facebook a more realistic valuation somewhere in the teens. Even at $20 the share price would be rich. The Facebook uberbulls were smoking banana peels (and the carnage has just begun).

Another nail in the coffin of efficient market theory, and one that demonstrates a few basic principles:

  • Markets are not efficient — they are MOSTLY efficient. Huge, huge difference. A market that is “mostly” efficient will place a reasonable / logical value on most assets, most of the time. But every so often it will completely go off the rails, or otherwise offer mispricings that traders and investors can profit from (or save money by staying away from). Facebook, the biggest IPO of all time, had ample warning signs that silly season had commenced.
  • Price is set at the margins. In a Sotheby’s auction, who gets the oil painting? The guy who is willing to pay the most, i.e. the one who makes the highest bid. In a hot real estate market, who buys the property? Again, the guy (or gal) who makes the highest bid. What does this have to do with the “rational” market value of the painting or the house being bought? Often very little, sometimes nothing at all. Market valuations — for growth stocks, real estate properties, paintings or whatever — are NOT determined by “a fair and sober assessment of value,” but rather, by the marginal impact of what the most enthusiastic market participants will bid.

  • Valuation is not the only factor that drives price. Efficient market theory teaches that “the market price is the rational / logical price.” But there are many factors driving price that have nothing to do with rationality or logic at all! Facebook’s private market value was in large part driven by “greater fool theory” — a self-reinforcing trend of belief that Facebook’s value would keep going higher. That “greater fool theory” mentality was carried over into the public IPO, with high school investment clubs trying to buy FB shares at the open in the hopes of “selling into the pop.”
  • When everyone agrees, prices get stupid. Studies have shown that crowd estimates can be surprisingly accurate on average — but only when there is sufficient diversity of opinion. Market valuations are the same way: When you have a diversity of opinion, reasonable estimates prevail as outliers cancel each other out. But when there is a critical mass of one-sided opinion — when an overwhelming majority shares the same general view — you get serious mispricings.
  • If you don’t know who the sucker at the table is… It’s the old poker truism, quoted by Warren Buffett and many others. “If you sit at the poker table for an hour and can’t tell who the sucker is, then the sucker is you.” This crusty old saying has some real wisdom in it: It is a way of asking What is your edge? If you don’t KNOW what your edge is… if you don’t understand how or why you are likely to prevail over your competitors… then it may be you don’t have one. Countless Facebook buyers thought that, because they understand what the company does, they understood the valuation case for the stock. Not the same ballpark. Not even the same sport!

Funny old world innit,

JS (jack@mercenarytrader.com)

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