The Stock Market: Reality vs. The Ideal

📈 The Stock Market: Reality vs. The Ideal

The perfect stock market, in a perfect world, would accurately reflect the monetary value of each company through the price of its stock. And, if a company improved its estimated value of its earnings, including well-computed earnings projections, the stock price would move proportionally. Similarly, if a company lost market share to its competitors, resulting in lowered earnings, its stock would fall in tandem, proportional to the company's lost value.
Analysts base much of their valuation of stocks on this ideal model, yet the model doesn't exist anywhere in the real world. Rather, a stock almost never reflects the true value of its underlying company, and for one simple reason:
A market consistently overreacts to news and other influential events.
In fact, it is this overreaction that makes trading possible! If the market were perfect—which is to say, if each and every stock were a true reflection of a company's value—stock prices would instantly reflect any change that occurred in economic conditions, and you would never be able to capitalize on anomalies of price.
This anomaly of price is meant that a stock's value is exaggerated in one direction or the other (it is grossly overpriced or underpriced, based on any reasonable value). In a perfect market, no such anomaly would ever exist, but the market is not or ever perfect, it often makes mistakes, sometimes of an alarming nature.
As an example, suppose there were an outbreak of war or some other national catastrophe. The illustration below shows what happened to the Dow Jones Industrial Average during the subsequent weeks that followed the 9-11 terrorist attacks. The event was certainly tragic by historical proportions, the public, nonetheless, overreacted to the situation, sending stocks far below a rational level. An astute investor, realizing the market's weakness, could have bought baskets of stocks near the bottom and ridden them back up for an 18% gain in only a couple of months.