What Are the Best Ways to Calculate the Stock Market?

There are two prices that are critical for any investor to know: the current price of the investment he or she owns, or plans to own, and its future selling price. Despite this, investors are constantly reviewing past pricing history and using it to influence their future investment decisions.

Some investors won’t buy a stock or index that has risen too sharply because they assume that it’s due for a correction. Other investors, however, avoid a falling stock because they fear that it will continue to deteriorate.

Momentum

“Don’t fight the tape.” This widely quoted piece of stock market wisdom warns investors not to get in the way of market trends. The assumption is that the best bet about market movements is they will continue in the same direction. This concept has its roots in behavioral finance. With so many stocks to choose from, why would investors keep their money in a stock that’s falling, as opposed to one that’s climbing? It’s classic fear and greed.

Studies have found that mutual fund inflows are positively correlated with market returns. Momentum plays a part in the decision to invest, and when more people invest, the market goes up, encouraging even more people to buy. It’s a positive feedback loop.

Mean Reversion

Experienced investors, who have seen many market ups and downs, often think that the market will even out over time. Historically, high market prices often discourage these investors from investing, while historically low prices may represent an opportunity.

The tendency of a variable, such as stock price, to converge on an average value over time is called mean reversion. The phenomenon has been found in several economic indicators, including exchange rates, gross domestic product (GDP) growth, interest rates and unemployment. Mean reversion may also be responsible for business cycles.

Martingales

Another possibility is that past returns just don’t matter. In 1965, Paul Samuelson studied market returns and found that past pricing trends had no effect on future prices and reasoned that in an efficient market, there should be no such effect. His conclusion was that market prices are martingales.

A martingale is a mathematical series in which the best prediction for the next number is the current number. The concept is used in probability theory to estimate the results of random motion.

For example, suppose that you have $50 and bet it all on a coin toss. How much money will you have after the toss? You may have $100, or you may have $0 after the toss, but, statistically, the best prediction is $50—your original starting position. The prediction of your fortunes after the toss is a martingale.

The Search for Value

Value investors purchase stock cheaply and expect to be rewarded later. Their hope is that an inefficient market has underpriced the stock, but that the price will adjust over time. The question is: Does this happen, and why would an inefficient market make this adjustment? Research suggests that this mispricing and readjustment consistently happens, although it presents very little evidence for why it happens.

Price is the driver of the valuation ratios; therefore, the findings do support the idea of a mean-reverting stock market. As prices climb, the valuation ratios get higher and, as a result, future predicted returns are lower. However, the market P/E ratio has fluctuated widely over time and has never been a consistent buy or sell signal.