What Determines the Level of Stock Prices?

It is common wisdom that sustainable earnings (defined as sustainable free cash-flow capacity, in this instance) determine stock prices. But in truth, what determines stock prices (since for a variety of reasons interest rates are mostly irrelevant in the long-term) is not the absolute level of earnings, but the capitalization or multiple placed on those earnings.

The capitalization or multiple is almost entirely (again since interest rates are irrelevant in the long-term) based on investors’ perception towards the future earnings capacity of the company. 

Since the multiple is entirely an interpretive phenomenon based on uncertain future expectations and colored by potentially flawed beliefs and emotions, stock prices almost never match economic realities. In fact, stock prices are always more volatile than the underlying business which these stock prices are supposed to represent.  

At the same time, this discrepancy between economic reality and the stock price, is the core reason why the stock market is mostly a casino. Since in the vast majority of cases, people are buying/selling stocks with absolutely no understanding of the underlying economic reality, and no true ability to forecast the future earnings capacity, most of the movements in stock prices are meaningless, and random, like the movement of a ball on the roulette wheel.  

The above idea opens up two possibilities for gambling profitably in the stock market, on the long side:

• Gamble on the 95% Noise

Focus on the 95% of the time where stock prices fluctuate meaninglessly, and attempt to outsmart the Market by buying low and selling high. This, is of course, a trading strategy, and I won't consider it right now for further analysis, even though it has strong merits, and some hedge funds (like Rennaisance), are apparently making a fortune off of the Noise movements.

• Gamble on the 5% Real Movements

Focus on the 5% of times where there is a legitimate reason for a stock price movement, such as when there is a significant event which changes the underlying earnings capacity and then bet on some sort of "reversion". The hunt for these "mismatches" between the true economic reality and the potentially flawed interpretation of this reality as reflected by the capitalization, and the prediction of the events/changes which can eliminate this "reversion", is, in fact, the process which underlies all successful investment programs.