Tuesday, December 13, 2011

Another day of testing for the market

Sure, the stock market may seem very "confused", diving one day and popping up the next, but there actually is a method to its madness. It is called "price discovery" and "testing." Some people do believe that they can calculate the fair and "proper" value for securities mathematically, but the stock market is designed to "find" the equilibrium price for stocks "the old-fashioned way", by "trial and error." Sure, maybe it does seem  kind of like a drunk or sleepy-head stumbling around in the dark (because it is!), but the magic of it all is that it works. Eventually, or at least on average over time, the market "approximates" the price of stocks based on the actions of all market participants. In practice, this simply means that stock prices move too far one direction and then too far the other direction, rinse and repeat, but if you draw a line through the middle of all of that "action" you will see the equilibrium price over time. So, the decline yesterday was simply the market "testing" if the recent rally moved up "too far too fast", and the rise early today was the market "testing" whether market participants really thought the equilibrium price was somewhere in the middle.
 
Now, the rise today may peter out and maybe even turn into an outright decline, or maybe turn into another "leg up" for the recent rally, but the testing process will continue as market participants incrementally "find" the equilibrium price for stocks, which of course is constantly changing as the real economy is constantly changing.
 
Meanwhile, during all of this volatility, true, long-term investors with money in quality, dividend-paying stocks get to enjoy nice gains simply as payment for tolerating the volatility.

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