With the stock prices rising so dramatically for many companies on apparently so little news, we academics take a lot of kidding about the efficient market hypothesis which says that the market price of a stock fairly reflects fundamental information about the company. Just what fundamental information is the market reflecting? In our defense, it is important to draw a distinction between informational market efficiency and fundamental market efficiency. As described in our book, The Conceptual Foundations of Investing, a market is said to be informationally efficient if it responds quickly to new information.
Tesla is a poster child for informational efficiency. The stock responds almost instantaneously to slightest hint of news. A tweet by Elon Musk can set the stock moving the instant after he hits the return key. But fast response to information is not the same thing as a fundamentally correct response to information. A market is said to be fundamentally efficient if stock prices fairly reflect fundamental value. That means when the stock price moves in response to information, it moves the right amount.
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Q2 2020 hedge fund letters, conferences and more
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Testing Informational And Fundamental Market Efficiency
Informational efficiency is easy to test. All a researcher has to do is check the time that a piece of information was released, say an Elon Musk tweet, and see how long it takes the stock price to react. Research shows that most stocks, and certainly Tesla, pass this test with flying colors. But although the stock price responds quickly to information, does it respond by the right amount? That is an entirely different question.
In most situations it very difficult to answer because of the difficulty of measuring fundamental value. As I write this analyst estimates of the fundamental value of Tesla range from $300 to over $2,500. With such a broad range of fundamental values there is no unambiguous way to measure fundamental efficiency except in special circumstances.
As my column last week described, one such special circumstance involved the Tesla stock split. Stock splits, in and of themselves, have no fundamental value. Nonetheless, in the four days following the Tesla split the stock soared $460.61 or 33.5%, adding $85.8 billion in market value. What is more the stock has continued up from there. If there is ever an example of a divergence from the predictions of fundamental efficiency, this is it. Either the stock was massively undervalued before the split or is massively overvalued know. It cannot be rationally priced at both dates.
The Canary In The Coal Mine
A natural response to the foregoing observation is, who cares? Tesla is a unique example. The stock is a favorite of day traders and Robinhood investors so anything can happen. Maybe so, but I am concerned it is the canary in the coal mine. Many other stocks, even Apple, are behaving similarly, although to a lesser extent. Once again, the response may be, who cares. This is a unique market with interest rates near zero. As I noted in a previous column, if the stocks of major tech companies are being valued like bonds then even higher prices can be rationalized. But the problem is should they be being valued like bonds? At Cornell Capital, we are fundamental investors who base investment decisions on comparisons of price with estimates fundamental value.
But if fundamental value and price are becoming delinked, what is a fundamental investor to do? In this regard, I recommend taking a look at the current post by my colleague Aswath Damodaran (Musing on Markets). Prof. Damodaran provides fundamental valuations for all the major tech companies along with detailed spreadsheets that readers and download and play with on their own. He is having a hard time explaining the current prices of even the most successful tech companies. He does not provide a valuation of Tesla but does note that he sold his stock at $640.
The bottom line is that the current behavior of the market, though entirely consistent with informational market efficiency, is a major challenge to fundamental market efficiency. Not only are prices of even the best companies extraordinarily high, but as Prof. Damodaran’s valuations imply there is increasing evidence that price and value are becoming decoupled. The Tesla stock split experiment is just the most dramatic example.
Finally, for those willing to dive into an academic study I recommend the paper from AQR, Is Value Investing Dead?. Based on a detailed economic study, the authors provide evidence for the decoupling of price and value even predating the post-Covid run-up that began on March 20. Based on a detailed economic study, the authors provide evidence for the decoupling of price and value even predating the post-Covid run-up that began on March s 20. A year ago, I wrote an article that concluded these were hard times for investors, the current environment is even more challenging.