Valuation, 7th Edition

7The Stock Market Is Smarter Than You Think

The stock market’s volatility and the sometimes-erratic pricing of companies’ shares have always raised questions about the link between stock prices and economic fundamentals. Some experts have at times even posited that stock markets seem to lead lives of their own. In 2017 the level of market valuations led Nobel laureate Richard Thaler to comment, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. . . . I admit to not understanding it.”¹ Several years earlier, another Nobel Prize–winning economist, Robert Shiller, wrote, “Fundamentally, stock -markets are driven by popular narratives, which don’t need basis in solid facts.”² American investor Bill Gross claimed in 2012 that the last 100 years of U.S. stock returns “belied a commonsensical flaw much like that of a chain letter or yes—a Ponzi scheme.”³

Does it make sense to view the stock market as an arena where emotions rule supreme? We think not. Certainly, irrational behavior can drive prices for some stocks in some sectors in the short term. And for shorter periods of time, even the market overall can lose touch with economic fundamentals. But in the long term, the facts clearly show that individual stocks and the market as a whole track return on invested capital (ROIC) and growth. For this reason, managers should continue to make decisions based on these fundamental drivers of value. By doing so, managers can also detect ...