When investors forget fundamentals, the market is broken

The share price on its own carries virtually no useful information, it depends entirely on how many shares the company has issued
The share price on its own carries virtually no useful information, it depends entirely on how many shares the company has issued

Summary

Best explanation for how stocks have moved so far this year is the raw price of the stock, an almost meaningless number

Sometimes it’s hard to argue that market capitalism has any chance of correctly allocating money to the companies that can use it best. Case in point: Stock-market performance this year has been driven by the raw share price, with lower-priced stocks doing better and higher-priced worse.

Forget a careful evaluation of future cash flow, valuation, brand power, management skill or even political sensitivity. I repeat: The best explanation for how stocks have moved so far this year is the price of the stock, an almost meaningless number.

Stocks priced below $1 have performed the best, followed by those between $1 and $2, and so on up almost perfectly. The worst performers have share prices above $100. It looks remarkably like investors are treating a low-price share as an indicator that the stock is a bargain, and a higher price as a sign that it is worse value for money.

The share price on its own carries virtually no useful information: It depends entirely on how many shares the company has issued. A company can split a high priced stock to create more at a lower price, without making any difference to the intrinsic worth of the company. Equally, it can consolidate its shares to reduce the number, increasing the share price but again without any effect on how much the company should be worth.

The fact that the stock price at the start of the year is a near-perfect determinant of how a stock has performed is depressing, but at least in part explainable.

The depressing part is the unknown extent to which it is due to the rising popularity of trading by individual investors, who are more likely to be new to the stock market and regard a low-price share as cheap, even though it should be irrelevant to a company’s prospects.

The explainable part is that the pattern could partly be the result of the widespread willingness to pile on risk, because rules on penny stocks and delisting make certain types of stocks riskier.

Penny stocks are those that, despite the name, persistently trade below $5, and for which brokers have to provide warnings, with some exceptions. This makes them less attractive to investors. Below $1 they run the risk of being delisted by Nasdaq and NYSE, making them much harder to trade.

The result is that a very low stock price is taken as a sign of a poor-quality stock, even though it could just do a reverse stock split to consolidate its shares and push up the price again. Usually being poor quality works against a stock, but there has been a general dash for trash across the market since the prospect of more stimulus began to be priced in ahead of the November election, with riskier stocks doing better.

Because regulations and stock-exchange rules mean a very low price is an indicator of trouble at a company, the rush into the junkiest stocks helps those with a very low price, too.

It shouldn’t make any difference once stocks are out of the danger zone, though—and yet it does. Logic fails, and this is worrisome. Stocks continue to do worse as the price rises, with the most expensive being the worst performers of all.

There used to be an explanation for why very expensive stocks—such as the A shares of Warren Buffett’s Berkshire Hathaway, which trade at $350,320—might lag: Private investors couldn’t even afford one of them. But even these are no longer out of the reach of the ordinary investor, thanks to fractional share programs run by many brokers.

It’s not a good sign that the stock market is being driven by a combination of investors misinterpreting what the stock price means and a rush to buy rubbish. The first makes the market function badly, as no one should be allocating capital based on the price alone. The second is a classic sign of too much risk taking, raising the danger that the rally ends badly.

My only reassurance is that this has happened before, if not in such an extreme way. A rush into the junkiest small stocks available is common at the start of the year, according to a 2015 study by AQR, which found low-quality stocks—measured by factors such as profitability, growth and credit rating—strongly outperformed higher-quality stocks in January, and especially so for smaller companies.

The pattern of lower-priced stocks doing better is neater in 2021 than in past years, perhaps because 2020 brought a flood of new stock traders armed with stimulus checks.

There is a reason to take more risk, as vaccine rollouts promise a return to a functioning economy; President-elect Joe Biden promises another round of stimulus, some of which will find its way into stocks; and the Federal Reserve promises not even to think about raising interest rates.

But I’m concerned. Stocks that fit popular themes such as solar and electric vehicles are already wildly overvalued, while signs of optimism abound in the wider market. Add in prices driven up fast purely by the arbitrary measure of how many dollars they cost and there’s good reason to worry.

This story has been published from a wire agency feed without modifications to the text.

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