How the market is priced pt 2 - the law of momentum in the human mind and the possibility of a "supreme valuation"
Years ago when my biz partner andI were saving up cash to start a biz waiting tables we had such jobs at many different restaurants and bars (as we basically always had 2 jobs, we kept looking for the best 2nd job and bouncing around a fair bit as a result). In joining many service staffs, we noticed a certain pattern that repeated itself fairly consistently. It was this:
1. you join the new job and generally everybody is fairly chilly towards you. guys are territorial, girls are distant
2. after a while, hours, days, weeks, you somehow strike someone as being a fairly cool chap
3. they tell someone, you make another friend or 3, eventually you get invited to some kind of get together for a beer or whatever
4. then you're invited to all the get togethers, the staff starts coming to your house for parties and
5. everybody loves you.
Its like once you get the ball rolling it takes on a life of its own and just goes, after a while of just going, you can't even stop it if you wanted to, at least unless something really dumb happened. Remind anybody of the stock market and the way it and individual securities behave?
Having this experience and talking about it alot led me to coin the "law of momentum in the human mind". Thats what we've called it, it may well have a real name, but I staunchly refuse to read any type of psych text until psych as a "science" makes an effort to make sense, but I digress. Here is how I would explain it if somebody asked me what I was talking about:
"ok, imagien that you judge someone or something on a bachelors scale, 1-10, with 1 being the worst and 10 being the best. Now imagine that you meet a guy named Tom, and he is the bees knees, the coolest guy you've ever met, so your first impression is a 10. Now imagine that you meet a guy named Joe and your first impression is "meh", whatever, just an average nothing 5.
Now imagine that a couple months later you realize that while Tom is a cool dude, he's not THAT cool, so he's an 8 now in your head. And then imagine that you got to know Joe a little bit and realized that he's not so boring, he's actually pretty cool, so he's a 7 in your head.
Well guess what? You like Joe better than Tom, because the human mind heavily rewards things that are improving and heavily penalizes things that are declining. Think of it as you add the momentum score to the real score, so Tom is a 6, because he's an 8 but he dropped 2 so you subtract 2 more. Now Joe is a 9, because he's a 7 but he's improving so you add 2 more"
And I do strongly believe that is true. The human mind hugely reacts to the momentum of their opinion of others in relationships of any kind, from short ones like talking to a salesperson while shopping to long ones like siblings. Momentum is a huge, huge factor in our subconscious's process of forming opinions of others.
We observed the same thing repeatedly in business. Repeatedly. You meet someone and they are pumped and psyched about your products and you and so frequently the relationship falters sometime later. You start a 10 and wind up an 8, now you're just a 6. The relationships that go the best start level, neutral, and grow from there - putting the law of momentum on your side. You know the old saying "under promise and over deliver"? Of course you do. All that is describing is the law of momentum in the human mind.
I would humbly offer that this plays a monstrous role in the stock market as well, and this basic reality of how humans view and rate things perhaps plays a huge role in how stocks get momentum and trend in one direction for sooooooo long, sometimes to wild extremely of valuation. Like ASH at 6, dozens of financials with price/books of 0.1 and no real chance of failure in march 09. Like the tech bubble and like precious metals at the end of this run and like CRM, or NFLX or AMZN today.
And, anyway, yesterday I offerd that it had recently occured to me that some people really don't focus on valuation but rather focus on fundamentals (of the biz, the industry, the economy, etc.), while still others primarily focus on momentum or "technicals" and so forth.
And it occured to me that I may very well be limiting myself by sitting here focusing only on value, owning low p/b and low p/e stocks and that a broader consideration that took into account all three categories:
1. valuation (pe, pb, p/s, peg, etc etc etc)
2. fundamentals (of the business, the industry, etc. etc.)
3. momentum (technicals and so forth)
If one could somehow compile a set of data that somehow related all of this:
A) for valuation maybe price to normalized earnings, price/sales, price/book, whatever, weight each different component appropriately according to the findings of the research
B) for fundamentas growth rate of the company, of the industry, market share moves, leadership position or not, etc.
C) for momentum some technical indicators or calculatable figures reflecting short term trend, intermediate, and long term trends (gold, for example, is in a huge long term trend, having been more or less straight up for almost ten years, but was recently in a short term downtrend, having fallen af ew percent).
... it would be a massive amount of work, weighting and calculating and moving and number crunching until the data fit, but I humbly submit to the group that if you did it, with a clear head...
... I honestly think that you would come up with a number that more accurately reflected the likelihood of a stock going up than any in existence today. I do. I do think the market can be ... solved, not perfectly, but ot the point where a reasonably distant approach would beat the indices without too much trouble. I wouldn't be surprised if even a reasonably dilligent attempt along these lines yielded some great results.
Anyway, I submit my belief in the possibility of a "supreme valuation" combining these 3 things. I am not, at this time, about to start working on it, but maybe... maybe someday. ;)