I recommend a paper entitled “The Stockmarket as a Complex Adaptive System” by Credit Suisse Director Michael J. Mauboussin. Unfortunately if you are looking for a new paradigm on how to value stocks and predict price change you will be disappointed.
To cut to the quick, Mauboussin opines that the best way to value stocks is still the traditional discounted cash flow analysis. A stock is worth the income it will receive in future years, discounted by an appropriate rate of interest.
He also states that on balance markets are probably efficient to a large degree and that there is no reliable way of achieving above market average returns year after year.
The more interesting part of the paper is its discussion as to HOW such apparent “efficiency” arises in markets.
His theory is that it is NOT because investors are super smart. And not because markets are lead by a few super smart investors – the lead steers.
Mauboussin points out that economists are still mired in traditional 19th Century classical physics and statistics. That there is “cause and effect” in markets and that prices can be predicted by classical statistical analysis such as the linear regression.
Probably quite rightly, he points to advances such as chaos theory and the related concept of complex adaptive systems to explain the apparent efficiency in markets.
Investors do NOT absorb all information regarding a company and rationally make investment decisions. And in any event this would not explain crashes or their opposite, “irrational exuberance”.
Rather than all participants acting wisely and in concert, there is a plethora of many different views and rules all of which combine, without the necessity for an organiser or creator, to produce market “efficiency”.
The whole is greater than the parts. From the simple actions of many different investors, a vast, unpredictable and complex system emerges, which is constantly changing and adapting and is largely unpredictable.
The simplest way of understanding this is to observe a flock of birds wheeling their beautiful patterns in the sky. Rather than the birds following a wise leader who knows the “Way”, each bird has a few simple rules which it applies.
The complexity of flocking arises from the application of those simple rules by each individual bird. The flocking effect is the result.
The theory is that this is how evolution works. No creator, no clockmaker, simply a few blind and simple rules played out over and over again my millions and billions of cells which eventually makes the whole bigger than the parts.
Emergence, to use the scientific term.
So there you have it. Markets are no more reliably predictable than the weather. It’s all about blind and unseeing self organisation.