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Markets Will Tell Us We Know Less than We Think

Sometimes, I feel that markets is efficient in the long run to price in crowded trades.

There were a lot of arguments about whether markets are really efficient. There will still be a lot. But I think people misunderstand what Eugene Fama means when he says the market is efficient.

I think he is not saying that the market at this point, is pricing exactly and correctly what is going to happen in the future but that it is a better mechanism in pricing in what is going to happen in a more efficient manner than a lot of other things.

We are not sure what will happen in the future, especially when different variables interact with different variables in the future. The market is better in forward pricing the resultant outcome better than a lot of methods financial experts have came up with.

I am not arguing about the efficient market hypothesis today. But strangely, I feel the market is really good at pricing in things in the future.

What a lot of us failed to grasp is that the market is like a system that prices in what happens into the future. This means that what we see in the markets is a reflection of what the companies in the index will do in the future.

It does not price so much of what the companies have done in the past.

One of the most prevalent narrative around April to July 2020 was how big the FAAMG stocks have gotten, as a percentage of the US stock indexes such as the S&P 500.

FAAMG stands for some of the biggest and most popular tech companies in the world (Facebook, Amazon, Apple, Microsoft, Google).

As a collective they have grow close to 21% of the US market cap and from the chart above, we can see how well they have performed in this very challenging recovery.

On hindsight, we can understand why they recovered so well. Their tech slant have allowed them to operate relatively unscath, and even thrive in a unique COVID environment where a lot of businesses cannot operate normally.

Naturally, investors looked at their resilience and believe their money is better positioned to be in these bellwether tech-enabled firms. So they piled into them.

Many may have switched from the traditional businesses that have been struggling.

Here is the technical charts of the five firms since July, which is the period where a lot of these FAANG or FAAMG versus the S&P 500 hit the media:

Microsoft
Facebook
Amazon
Apple
Google

With the exception of Google and perhaps Apple, the prices of these bellwether tech-enabled firms have consolidated for 5 to 6 months.

In this period, all five companies have announced great results that showed how well they navigated the past. Not just that their guidance going forward is great as well.

So why didn’t they performed during this period? I could cite a lot of reasons such as tighter regulation coming to this big tech but I felt that in a way… market has a way of telling us a lot of things in the future is priced in.

The market is like a constant weighing machine of the aggregate future cash flow. The markets, which is a mix of aggregate future cash flow and our psychology overshoots to the upside and overshoots to the downside. The market will keep trying to find the equilibrium but it may never find it.

Here is a performance comparison of the Russell 1000 ETF (IWB) vs the Russell 2000 ETF (IWM).

The Russell 1000 represents the top 1000 companies in the United States and the Russell 2000 represents 2000 of the smallest companeis in the United States.

Jun 2020 to now

Since Jun or Jul, the smaller firms have done much better than the large companies. The smaller companies, whether they are cheaper, neglected or struggling, maybe performing better because a return to the norm is better for their businesses.

I find that the market has a constant way of humbling us and telling us that there are aspect of the markets that we can try to fortell but we may not be able to do it very well.

The biggest problem for many of us is we derive what will happen in the future from what we see in the past.

But if the market is an aggregate of future cash flows or trying to price in what happens in the future, then we are interpreting what we see in the price movement the wrong way.

Next time, when you look at a price surge or a price drop, try and think what the market is pricing in the future and not the past.

Predicting the future is tough, predicting the future is not going to change and be similar to the past is easier.

But we know that the future always look different in some ways compare to the past. How similar is the world today versus the 1990s?

How successful, how fast would clean energy, artificial intelligence and genomics change us?

The execution and speed affects forward pricing.

There are a lot of unknowns in what is new and I find that markets will always have a unique way of telling us we are wrong or right.

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