CINCINNATI BUSINESS COURIER
July 21 – 27, 1986
INVESTMENTS
Charles D. Vaughan
“THE SHADOW KNOWS!”
Radio buffs will recognize that as the answer to the question, “Who knows what evil lurks in the hearts of men?” While there may be no mythical Lamont Cranston to solve our problems for us, it is possible that the shadow may provide us with some answers that are not obvious in the bright light of day.
Such may be the case in seeking explanation for the 150 point drop in the Dow Jones industrial average that occurred during a week in which the Federal Reserve dropped the discount rate a half point. How is it possible for stocks to suddenly be worth 5 percent to 10 percent (and some worth 20 percent to 30 percent less) than they were the week before in the face of bullish news?
The answer lies in the manner in which stock prices are formed. A transaction in a given stock takes place at a price determined by a two way auction market. That means buyers, through brokers, “bid” for a given stock by publicly stating what they are willing to pay, while sellers make public “offers” of what they are willing to accept. When a bid and an offer converge, a transaction is made for the stated number of shares.
Security analysts for generations have stalked the elusive concept of real or “intrinsic value” as hunters have pursued Bigfoot with much the same result. Whenever it seems to be just within sight, it somehow mysteriously slips away into the bushes.
No, prices for stocks are not determined by professional appraisal firms that place a value on each stick of furniture and each piece of real estate. The process is more like the way a house is priced. A house is really worth only what a qualified buyer is willing to pay. Stocks are too, except that security markets are much more highly organized and prices are reported instantly.
Picture for a minute the familiar blue blockletter logo of IBM. See those three letters as a massive three dimensional form standing in front of you, brightly illuminated in the light of full financial disclosure. Think of that logo as a representation of the company. Now visualize behind that three dimensional logo a long, deep shadow of the logo. Think of that as the market value of the company’s stock.
If the light shines upward from below the logo, the shadow value is high above the logo. As the light moves upward to shine down upon the three dimensional logo, the shadow value falls below the logo. A small movement in the light can create a greatly exaggerated change in the size and shape of the shadow. Thus, a small decline in the earning power of the company can precipitate a large drop in the value of the stock.
The real or intrinsic value of a given company is impossible to define. The market value of the company is based upon the collective opinion of all stockholders and potential stockholders of the company. Their valuation is based less on the value of what the company is at the moment than upon what it might be in the future. This undefinable difference between the theoretical value of the company and the market price is what I call the shadow element.
If it were possible for the stocks of companies to sell at their real intrinsic values, there would be no shadow element and the stock market would be a pretty dull place. In a high volume market such as we have seen for the past two years, we can see the “greater fool theory” at work. That is, stocks sell not so much for what investors believe companies to be worth, but for what people believe someone else (a greater fool) may be willing to pay. In other words stocks go up because people in general believe they are going to go up.
When something happens to change that commonly held view that is, the position of the light of public opinion shifts prices (or the shadow values) move dramatically. Stocks may then go down because the investing public thinks they are going to go down and more people want to sell than to buy. The value of companies in reality may have changed very little, but the prices that people are willing to pay may have changed substantially.
When events don’t make sense in the financial markets, don’t look to the news for explanations; look instead to the shadow of public opinion. Reality is a matter of perception. Perhaps the shadow really does know.