When we don’t know what something is worth, we tend to look to the market for guidance. How are other people pricing it? We assume there’s wisdom in the crowd.
But the problem occurs when the majority of the crowd is also looking to the crowd for guidance. When the blind lead the blind like this, disaster happens: too many people following the market’s trend, and not enough people thinking independently.
When market price is being dictated by illogical behavior in the short-term, why should a logical investor look to the current market price as absolute truth?
Fred Carach, a retired real estate appraiser and micro cap value investor, also wondered the same thing. In his book, Forty Years A Speculator, Carach describes his “eureka moment” as a stock investor when he realized the stock market didn’t technically behave like a market when tested against the official definition of market value used by real estate appraisers:
…[Market value is] the most probable price a property should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with buyer and seller acting prudently, knowledgeably, and for self interest and assuming that neither is under duress.”
Fred Carach, Forty Years A Speculator (page 52)
I know, it’s a long definition. But if your eyes glazed over it the first time, read it again. If you’re the type of person who still stresses over what the market thinks of your stocks, these words could set you free from that spell:
Market value is the most probable price a property should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with buyer and seller acting prudently, knowledgeably, and for self interest, and assuming that neither is under duress.
Why is this such an enlightening definition? Carach explains:
Today, the stock market fails the above test in two ways. First it is dominated by armies of day traders and momentum players who aren’t acting knowledgeably. They have no independent opinion whatsoever as to the worth of the stocks that they are buying and selling. Indeed they would correctly regard having an opinion on the market value of the stocks that they are trading as dangerous. After all, it might conflict with that of the market. And just where would they be then? They are forever chasing the latest trend. In no sense are these armies of buyers and sellers making independent, knowledgeable decisions about the market; which is what a market value requires.
The second way the stock market fails the above test is the question of duress. Fear and greed are everywhere. In any given day it could be argued the majority of the buyers and sellers are operating under duress, often under severe distress. Therefore the stock market fails the requirements of a market in the short-term, but not the long-term.
[…]In the long-term [a stock’s price] does indeed oscillate around [fair] market value. But in the short-term it is nothing more than a random action machine, as herds of so-called investors mindlessly stampede hither and yon driven by fear and greed based on the latest tout or news report.
This enlightening discovery led Carach to write:
The realization that I wasn’t competing against a market freed me. I knew I couldn’t compete against a market, but I had every confidence that I could compete against a herd of cattle.“
Benjamin Graham famously personified the unreliability of seeking truth in stock prices with the character, Mr. Market, in his 1949 classic, The Intelligent Investor. It’s fascinating to see how Carach came to the same conclusion as Graham, albeit in his own way as a real estate appraiser. Prior to this realization, Carach had struggled to find success in stocks until he stumbled across the profound truth that “Mr. Market is there to serve you, not guide you.”