Who Set The Price?
I’d like to invite you to look at a recent, not atypical, four day chart of a stock. In this particular case, it’s SiRF Technology Holdings (NASDAQ:SIRF).
As you can see, the stock gapped down from the $25-$26 it had been trading at to the $19-$20 range. You see this kind of thing all the time when “bad” news comes out.
The question I’d like to raise today is: who set the price?
Why did it go down to about $19? Why not $17? Why not $23?
To understand, let’s look at some of the news report headlines. Perhaps they can give us some insight as to what happened.
- SIRF 2Q Profit fell after charges: Sales up 61%
- SIRF Q2 EPS Declines on Higher Expenses Despite Increase in Revenues
- SIRF shares plunge on 3Q outlook
Here’s a great company with long term growth prospects, numerous design wins, whose growth (while strong) isn’t quite what some traders would hope to see, and whose operating earnings continue to grow, but this quarter’s earnings were hit due to acquisitions and option costs. It’s a major player in the GPS space - an area that has huge short/medium term potential, as I describe in an earlier article “Thinking About Garmin“.
Logically, this is and remains a solid growth company. Yet we know that nowadays a stock can drop on any news. Even a perfect report can be followed by a drop in the share price - often explained away as investors selling because they don’t expect the next quarter’s news to be as great.
But today’s story isn’t about SIRF - that’s just the background.
Today’s question is: who set the price? Is it based on forward earnings? Some sales ratio?
Traditional marked theories would suggest that this price was set by many thousands of investors and traders, each evaluating the earnings report independently and deciding a fair value for the stock.
I would suggest that this is nonsense.
I recently proposed a new theory I call The Stupid Markets Theory that states that human stupidity is the fundamental force behind market pricing. Its main precepts are:
- The price of a share is determined by the market, but in the long term the price will have a relationship to the value of the stock (based on the value of the company).
- Most short term movement of a stock is a result of the decisions of a relatively few traders who are either reacting to information based on their own biases, acting illegally on inside information, or intentionally manipulating the stock. As such, a significant amount of this movement will be fundamentally stupid.
- Most explanations for short term movement of a stock or the market are rationalizations - attempts to add reason to the inexplicable.
So, why did SIRF drop as it did?
Answer: Because the morning after the announcement when trading started, some computers woke up and had to resolve an imbalance in buy and sell orders. One or more traders out there had set up their computerized trading system to buy under about $19.50. So the exchange computers found they could match up orders at that price, and started trading. At that point, everyone else figured that was about what the stock was worth - not through their own analysis, but because a few traders had arbitrarily picked that price earlier. And so the stock sat in that range for the next 3 days while other traders tried to figure out what might happen next.
Why did that handful of traders pick $19-$20?
We don’t know. But we do know one thing about those traders: They are human (and, if the price was set by computer, its programmers are human - so it’s an indirect variation on the same theme).
That means there is a strong chance that decision was a stupid one. This is based on the Dilbert Principle and Peter Principle. We are all idiots some of the time. People do get promoted to their level of incompetence. Traders and financial advisors are no wiser than politicians, lawyers, or anyone else for that matter.
The Stupid Market Theory would argue that the choice of $19-$20 for the price of SIRF over those three days was completely arbitrary. Like any short term pricing, it had no relationship to the company’s value, or to news about the company, and that any explanations for that price are rationalizations after the fact (as Heinlein said - human beings are rationalizing creatures, not rational).
What does that mean for SIRF? In the short term, I have no idea. In the long term it will depend on how the company does - a topic for another day.
What does the Stupid Market Theory mean in terms of an investment philosophy? This is something I am continuing to work on and will be writing more about in weeks to come. Accepting that the market is fundamentally irrational (stupid) is contrary to most of what I’ve seen and read. Remember though, this is just a theory. I have not proved it, nor do I entirely believe it. Yet it is interesting enough to be worth studying and taking to its logical conclusions just to see where it might lead.
Dan Appleman is a veteran author and entrepreneur who is currently writing on investment and personal finance issues as a form of self-imposed homework under the principle that the best way to learn is to teach. Read more of Dan's work at ThinkingAboutMoney.com.
11 Comments Add your ownSubscribe
1. Brian | August 11th, 2006 at 3:39 pm
I love the concept of your theory! It is the fundamental basis for finding value stocks, taking advantage of a stock on sale due to sellers forcing the stock price unaturally low.
2. Brennan Woods | August 11th, 2006 at 8:58 pm
In the long run the market is almost always right. Of course the markets are going to either over-sell or buy a stock, in the short run, but these corrections are what makes the market exciting and profitable for the smart trader.
3. Allen S. | August 12th, 2006 at 11:00 pm
I used to wonder about those same gaps myself…until I read “Day Trade Online” by Christopher Farrell. It turns out that on the NYSE and Amer. Stock Exchange, each stock has a specialist who sets the price. He’s the same guy who sets the bid ask spread. He makes money on that difference, but also risks money on setting where the stock will open. He’ll buy (at his setting price) when everyone else wants to sell on bad news. He knows that stock better than anyone else and thus has a good idea of where to set the opening. Farrell describes it fully in a couple of chapters.
Allen S.
4. 7thseer | August 13th, 2006 at 12:59 pm
Good article. It is amazing how many market contributors agree on the price level so quickly after good/bad news. I have always thought the large institutional traders mostly set the general level for the stock by the sheer mass of their trades. And then there are the stocks with very little volume.
5. Nathan | August 14th, 2006 at 10:46 pm
I agree with what Allen said. Prices are not really set arbitrarily. The market makers set the price at which they try not to lose money, when accepting market sell orders at the gap.
6. Brennan | August 14th, 2006 at 11:29 pm
“Given that a market is simply people coming together to buy and sell things, it is sometimes odd to reflect on how the market seems to be an independent living entity - something with a purpose of its own. And its implacable…We know markets are simply the accumulated decisions of multitudes of people, but we still tend to think of a market as a conscious thing rather than a process.”
-”The Nature of the Beast”, Active Trader Magazine (August 2006)
If you all take a look at the 1 year chart, the price broke out of its upward trend late April. This said, the price dropped significantly from July 3rd to the 13th and most notably, July 25th. Dan refers to this as just “bad news” however a negative earnings report is just plain BAD, no quotations necessary. I agree with Dan in that surely a great number of investors noticed the sell-off and ran with it without doing their due dilligence and researching the stock for themselves, instead of identifying the specific reasons for the sell-off. Still, the stock was in a downward trend since April and this should have been a sign to any investor that SiRF was headed for trouble. Take a look at Apple which has much better long-term growth possibilites and stronger financials. Since AAPL came out August 11th and said they would restate earnings the stock has remained flat, in fact, it was even up a dollar or so within the past five days. This information can certainly be viewed as “bad information” but the market, or rather - those individuals that comprise the market, felt Apple would rebound. I lean towards agreeing with this sentiment as Apple is off of its 52-week high of $86.40 but then again…maybe I’m just a little emotional with this investment…I held on to AAPL too long selling short of its high in January. Thankfully I’m just one investor helping to comprise a dynamic and INTELLIGENT market.
7. thebulltrader.com | August 15th, 2006 at 2:11 pm
the price target on a gapdown is dictated by support levels. technical analysis is what determines short term stock prices, not fundamentals.
8. Brennan | August 15th, 2006 at 5:28 pm
Of course the gapdown is dictated by the first and second support levels but when the price falls below these supports one must take into consideration both fundamental and technical indicators in determining whether or not the current price is justifiable. Since the stock was in a downward trend to begin with an intelligent investor would anticipate a greater sell off than might be appropriate and would in turn buy at that time. A day trader would then have new support and resistance levels to consider.
9. Dan | August 18th, 2006 at 1:09 am
>Still, the stock was in a downward trend since April and this should have been a sign to any investor that SiRF was headed for trouble.Since the stock was in a downward trend to begin with an intelligent investor would anticipate a greater sell off than might be appropriate and would in turn buy at that time.
10. Dan | August 18th, 2006 at 1:16 am
Repeat - earlier comment was cut off:
Still, the stock was in a downward trend since April and this should have been a sign to any investor that SiRF was headed for trouble.
The fact that the stock was declinding does not necessarily indicate the company was in trouble - just that the stock price might be in trouble.
Since the stock was in a downward trend to begin with an intelligent investor would anticipate a greater sell off than might be appropriate and would in turn buy at that time.
I’d like to think that makes me an intelligent investor, but don’t give myself that much credit. Still, it was nice to come back from vacation and see the current price over $24
11. Timothy | February 3rd, 2007 at 2:06 pm
What a great site
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