Understanding how markets work is really quite simple, as I’ll show here.
Pictured below is a publicly-traded asset. It can be a stock, a bond, a commodity, or a fund comprising any or all of these asset types. It can even represent, with a little imagination, your home. It’s difficult to extend it to some things, like collectibles, such as works of art or even gold.
Figure 1: This is a hypothetical example used for illustrative purposes only and is not representative of any specific investment.
Here’s how it works. The blue line represents something called intrinsic value (IV), which I use here to represent what others might call fair value. In the world of the steely-eyed Wall Street analyst, he or she would consider this his or her so-called price target, although the price target would probably be represented by a stair-step line, as price targets are only periodically adjusted. More on analysts in the following paragraphs.
The IV is shown here as constantly changing. It changes in response to multitudinous interest rate changes, changes in economics, and so forth. In the world of finance, depending on one’s financial worldview, this represents some version of market efficiency. Burton Malkiel, author of, A Random Walk Down Wall Street, and others refer to the strong, semi-strong, and weak versions of market efficiency. There’s enough material in those three words for innumerable blog posts. Suffice it to say, depending on which of those one uses, the blue line represents some version of all the information that might be known, knowable—or in the strong version of the theory—even unknown. The blue line is not, however, affected by investors.
That’s where the red line comes in to play. It represents the market price, and the market price—or just price if you extend the case to your home, for example—incorporates all investors’ emotions, as well as what they consider their steely-eyed estimates of what fair value is. Often, though, they forget that they are driven by their emotions.
So, here are three things to keep in mind:
- When investors sell assets in panic, the red line goes down.
- When investors are enthusiastic about asset prices, they buy enthusiastically, and the red line goes up.
- When the red line is below the blue line, one can say that pessimism is ruling the day. An unemotional analyst might say the asset is undervalued and should be bought. On the other hand, a market price above the fair value, represents an asset, the price of which has been driven too much by optimism.
The third point could also be put this way:
An asset is overvalued when its price is greater than its IV (red>blue); undervalued when less (red<blue). This is the classic Warren Buffett type of analysis.
Here’s the final thing to remember, and it might be the most important. Intrinsic value is unknowable. Entire industries, careers, and empires, however, have been built on the idea that it is knowable, or at least knowable enough—or estimable enough. Even though intrinsic value is unknowable, it is an important concept for you to keep in mind, especially at times when you’re feeling the gnawings of panic.
In a later post, we’ll look at what you can do to fight against getting caught up in the emotional swings of the market.