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What Makes the Stock Market Tick?

People buy a stock because they think it will go up in value. They usually sell a stock when they think it will go down in value. I say usually because people sometimes sell a stock when they need money for other purposes. Leaving aside this case, it is clear that every buyer needs a seller and they both have conflicting views about what the stock will do in the future.

They can't both be right. Assuming both buyer and seller have access to the same information, how can they come to such different conclusions?

The same information can be interpreted differently by different people. Human beings tend to look at things in a very biased way (see cognitive biases). Many stock market players suffer from confirmation bias. They only look at information that confirms their view of where the market is going. When bullish sentiment is high, the smallest bit of good economic news can send the market higher while bad news is simply ignored.

You also have the '''noise traders''' who act primarily on price action. These are trend followers and momentum chasers who have little use for any solid information. They trade almost exclusively based on trends, fashions, sentiments, rumors, and emotions.

Finally you have to question the assumption that everyone has access to the same information. This is another one of those things that only an economist could believe. Some people will always have better sources of information than others. The insider information problem is something that can never be completely solved.

In any case, market activity is a sign of confusion and differing expectations about the future. The more market activity there is, the greater the confusion.

Is market activity solely determined by people's expectations of capital gains? Is it possible that prices reflect nothing more than trends, fashions, and sentiments? This is the casino view of the stock market. You buy a stock because you think that in the future someone will come along that is dumb enough to pay you more for it than what you bought it for. When this happens you have won. You quickly sell, pocket the profit, and go in search of another opportunity to sucker someone.

The casino view is true to a certain extent. There are a lot of people in the market who operate on this principle.

Keynes described the fluctuations of stock market prices as a beauty contest. (see Keynesian beauty contest). Consider a beauty contest where everyone is shown pictures of women and is asked to pick the one he thinks is most beautiful. The results are tallied and everyone who picked the winning picture gets a prize. The stock market is like a beauty contest where the stocks are the contestants and everyone is trying to guess who will win.

An interesting aspect of this kind of contest is that the optimal strategy is not to pick the picture that you think is the most beautiful but to pick the picture that you believe most of the others will pick. How much of this kind of thinking goes on in the stock market? Hard to say.

The stock market cannot be entirely a beauty contest. If it was, it would be too chaotic and boom and bust cycles would be more frequent and severe. There must be market participants that buy stocks based on some fundamental notion of their value. It is really impossible to objectively determine an absolute price for a stock. I think the best you can do is to look at relative price comparisons. If one stock is priced significantly higher than another but there is no significant difference between them and no reasonable argument can be made to justify the relative price difference then you can be reasonably sure that the higher priced one will have to fall and the lower priced one will have to rise in price.

Or maybe the stock market is just a Russian fashion show:

© 2010-2012 Stefan Hollos and Richard Hollos

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