The Role of Price In Stocks

A short comment about a shorter Yglesias article. Typically I find myself nodding along to some of his observations about the market: the dichotomy between Yahoo!’s profitable business compared to Amazon’s razor-thin margin. In this particular article, he implicitly questions the mental soundness of Apple stock falling after continued revenue growth across its key units- especially iPhone.

In general, I do agree with some of the “thrust” of what he’s saying about Apple’s earnings and the general valuation of tech stocks. But, implying negative stock movement is arbitrary/unfair/unreasonable after Apple stock fell because it didn’t meet expectations is entirely wrong. Again: maybe the overall valuation should be much higher if you think the P/E ratio for such a mature company is ludicrous. Maybe you think it should be lower since Jobs is gone and Apple is going to kill the golden goose soon. That does not change one hard fact though: if the price of AAPL is $100 on day 0 (the day before earnings are officially released), that price encompasses everything we know about it. Thus, if something we know about it changes or is incorrect the price should change accordingly. Many investors trade specifically trying to profit off these margins of information or expectations.

So when we hear on day 1 that actually, the earnings of the company were -10% of what we thought they were, the price should accordingly fall, every time- even if the earnings were still positive! We can even abstract one level away further about price: historically, AAPL has outperformed market expectations. Eventually, this consistent behavior gets built into the price on day 0. So in fact, a “miss” of 10% on the analyst’s reports might actually lead to a greater fall in the price.

Note that this means if analysts become more accurate overtime in their expectation, this actually hurt Apple stock in the short term before the market recognizes the analysts are closer in their predictions, even though Apple as nothing to do with this process directly.