Emotions and Mispricing in the Market
Chapters 15 and 16 set out the evidence that stock market valuations correctly reflect underlying economic fundamentals in almost all cases and nearly all the time. But what about those episodes when markets appear to part company with reality? We agree with proponents of behavioral finance that emotions can get the better of investors at certain moments. But turning to the evidence again, we find such moments do not last very long and rarely involve more than a few companies or sectors. For the U.S. and European stock markets, we find the following patterns:
• Individual company share prices deviate significantly from the company’s fundamental value only in rare circumstances—typically when barriers to trading, such as too limited a free float of shares, prevent rational investors from moving in to correct the price.
• Market-wide price deviations from fundamental valuations, as in the dot-com boom of the late 1990s or the soaring prices triggered by expectations of unsustainable corporate profits in 2007, are even less frequent, although they may appear to be becoming more so.
• In the vast majority of cases, price deviations from fundamentals are temporary. Market-wide deviations are typically corrected within three years. Company-specific deviations usually last only as long as the barriers preventing a price correction.
Although random deviations from intrinsic value can occur in stocks from time to time, managers are still best off assuming ...