Are Economic Facts Driving Stock Prices or Merely Rationalizations for Existing Price Moves?

As mentioned in prior posts, stock prices for legitimate companies, and prices of other paper assets, are more a function of psychological factors, than economic realities. In fact, in many instances, economic facts are used to justify a price rise (or fall), after the fact. So in reality, the economic rationalization is a reaction to the price change, rather than a cause. It is used to “defend” the price change, or “market” the story.

Of course, an initial price movement off of a steady base may in fact, and is nearly always, due to specific economic considerations, but after that initial move the continued price rise is chiefly due to psychological factors (e.g. crowd psychology), with the economic facts merely providing support for the “bull” run.

What generally seems to happen, is as follows: Some stock, or asset, basically goes nowhere for quite some time. It displays little volatility and a tight range of prices, combined with a low valuation relative to underlying business fundamentals (this in fact the type of conditions you want to have before investing in any stock).

Some event subsequently changes the economic outlook for the company or asset, and a few investors recognizing the changed conditions begin buying the stock. This causes the price to rise. Thereafter, continued price rises are a function of other investors jumping on the bandwagon and fundamental results simply justifying the initial rise. However, in general the initial price rise will happen quickly, and will greatly eliminate any rational justification for the continued price rise. In other words, the game quickly changes from finance to psychology. 

The practical effect of the above, is that one needs to be very careful when analyzing any asset to understand the economic justification for a price rise, making sure that the economic reasons are not being used to rationalize the price rise. In fact, you need to be sure that you are buying in early into the story, before a major price rise, when the improved economic fundamentals are still unknown or underappreciated. Once the news it out and the game changes to psychology, it’s best to just sell and look for something else to invest in, no matter how much profit is left on the table.

As mentioned in the past, in any ponzi scheme, like the stock market, it’s important to Get In Early, and Get Out Early!