It is essential for an investor to know two prices: the price of the investment they currently own or plan to own, and the price at which they will sell it in the future. However, investors often look at past pricing history to predict future prices. For instance, some investors avoid buying a stock or index that has risen too quickly, fearing a correction. Others avoid stocks that are declining, expecting them to continue falling.
The recent price indicates these types of predictions. Does academic evidence support these predictions? In this paper, we discuss four different views of the market, relating them to academic findings. These conclusions will help you understand how the market functions and perhaps eliminate some of your biases.
Momentum
"Don't fight the tape." This widely quoted stock market wisdom advises investors not to go against market trends. The idea is based on behavioral finance, suggesting that market movements tend to continue in the same direction. With many stocks to choose from, why would investors keep their money in a falling stock rather than one that's climbing? It's classic fear and greed.
Studies show that mutual fund inflows are positively correlated with market returns, indicating that momentum plays a role. When more people invest in the market, it rises, enticing even more people to buy, creating a positive feedback loop.
A 1993 study by Narasimhan Jegadeesh and Sheridan Titman, "Returns to Buying Winners and Selling Losers," found that individual stocks exhibit momentum. Stocks that performed well over the past several months tend to continue outperforming in the following month, while poorly performing stocks tend to continue underperforming. However, this momentum effect reverses over longer periods. For example, a 1985 study by Werner De Bondt and Richard Thaler, "Does the Stock Market Overreact?" showed that strong performers over three to five years were more likely to underperform in the next three to five years.
This indicates another factor at play: mean reversion.
Mean Reversion
Experienced investors often believe that the market will even out over time. Historically high market prices tend to discourage investment, while low prices may represent opportunities. Mean reversion refers to a tendency for a variable, such as stock price, to gravitate back toward an average value over time. Some economic indicators, like exchange rates, GDP growth, interest rates, and unemployment, also exhibit mean reversion, which may cause business cycles.
The evidence on whether stock prices revert to the mean is mixed. Some studies show mean reversion over long investment horizons, while others do not. For example, a 2000 study by Ronald Balvers, Yangru Wu, and Erik Gilliland found some evidence of mean reversion in the relative stock index prices of 18 countries. However, they noted that detecting mean reversion is challenging due to the need for reliable long-term data.
Academia has over 80 years of stock market research, suggesting that if mean reversion exists, it occurs slowly and almost imperceptibly over many years.
Martingales
Another view is that past returns are irrelevant. In 1965, Paul Samuelson's analysis showed that past pricing patterns did not affect future prices. He concluded that in an efficient market, prices are martingales.
A martingale is a mathematical series where the best prediction for the next number is the current number. In probability theory, this concept estimates the results of random motion. For example, if you have $50 and bet it all on a coin toss, you would either have $100 or $0 after the toss, but on average, the best prediction is $50—a return to your original starting position.
Options are priced on the assumption that stock market returns are martingales. By this theory, the option's valuation is independent of past trends or future estimates, relying only on the current price and estimated volatility. The market price's best forecast for tomorrow is today's price plus a small increment, reflecting a random walk with upward drift. Investors should focus on managing the risk of volatile investments rather than relying on momentum or mean reversion trends.
Looking for Value
Value investors buy discounted stocks with the hope that the market has mispriced them and that their prices will realign over time. Research shows this mispricing and adjustment consistently occurs, though the reasons remain unclear.
Gene Fama's 1964 research and subsequent work with Kenneth French developed a three-factor model explaining stock market prices. The variable most explaining future price returns was the price-to-book ratio. Stocks with low price-to-book ratios significantly outperformed others.
Sanjoy Basu's 1977 study found similar results for stocks with low P/E ratios, a finding replicated in many other markets. The continuous mispricing and later adjustment of "value" stocks remain unexplained, but one possible conclusion is that these stocks carry extra risk, for which investors demand compensation.
Price drives valuation ratios, supporting the mean-reverting stock market hypothesis. When prices are up, valuation ratios are up, and future returns are lower. However, the market P/E ratio has fluctuated widely and has never been a consistent buy or sell signal.
The Bottom Line
Decades of financial research have yet to provide a solid answer. However, there may be short-term momentum effects and a weak long-term mean reversion effect. Valuation ratios like P/B and P/E, which use the current price, have some predictability in future returns. While these ratios are not complete signals for buying or selling, they are factors that influence expected long-term returns.