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).

SiRF Chart from Google Finance

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.