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The Best Interest » Priced In: How The Stock Market Reacts to News

Priced In: How The Stock Market Reacts to News

I love today’s topic—“pricing in” future events. As with many stock market ideas, it combines both rational and irrational thinking. (The stock market, irrational?!) Today’s idea combines math and psychology—two blog favorites. We’ll pull fun analogies from sports betting and beauty contests and the NBA draft.

If you ever wondered, “What does ‘priced in’ mean?”…today’s post has the answer.

What Does “Priced In” Mean?

Priced in” means that future events are already being considered in determining the price of a stock (or asset).

Expectation and anticipation cause traders to buy and sell stocks before the event they’re expecting or anticipating actually occurs. As the event becomes more likely to come true, the event gets more priced in.

Wonka Suspense - Reaction GIFs

The anticipated event often comes to fruition and the stock market barely reacts. Why? Because the expectation and anticipation have already priced in the event itself.

One of my favorite quotes from Burton Malkiel explains the concept perfectly:

If it were obvious a stock will go up tomorrow, why wouldn’t it go up today?

Burton Malkiel

Doesn’t that make sense?

If everyone knew that Apple stock was going up to $200 tomorrow, people would buy it today. As long as you buy today under $200, it’s a smart move.

But the act of buying—a.k.a. increased demand—would push the price up. The price would settle at $200. Why? Because there would be no demand to buy the stock at $201. Buying at $201 would be dumb if we know it’s only worth $200.

The prophecy has fulfilled itself, albeit a day earlier than expected. The price didn’t go up to $200 tomorrow. It went up to $200 today. The news of tomorrow’s increase got priced in before tomorrow acutally occurred.

This is a simple example of future events getting priced in to a stock price. The real world is more complex than Malkiel’s quip. It’s never that obvious. But news gets priced in to asset prices every day.

News Is Priced In To Tesla’s Stock

Let’s take a real-world look at Tesla. Why is Tesla up 800% since the beginning of 2020?

Tesla delivered 500,000 cars in 2020. They delivered 367,000 cars in 2019. But that’s not 800% more cars!

Nor did Tesla build 800% more manufacturing facilities. Their 2020 revenue stats aren’t reported yet, but their third-quarter revenue was only 39% more than their Q3 2019 revenue. That’s not 800%!

So how can we explain Tesla’s 800% stock growth? You guessed it. Future expectations are being priced in to the stock. Some people call this “pulling forward” future profits. Analysts believe that Tesla will eventually justify its high stock price.

If I expect that Tesla is going to produce 5 million cars a year by 2025, then that should be priced in to their stock today. If Tesla will have $200 billion in annual revenue by 2030, then that revenue should be priced in to the stock today.

The market is already leaning forward on Tesla, and now Elon Musk’s feet (wheels?) need to play catch-up.

Top 30 Cybertruck Glass GIFs | Find the best GIF on Gfycat
The shatter-proof Cybertruck windows. Oops!

Is “pricing in” always accurate? Of course not. I’m sure some optimism around Tesla is misplaced. It’s psychological. It’s irrational. …We’ll get into that later.

Good News, Bad Results

Pfizer is one of the leading developers of the COVID-19 vaccines. Surely their stock would be a smart purchase…right?

If that’s the case, then we need to examine why Pfizer’s stock price is down ~15% since mid-December 2020. And the problem involves too much good news being priced in.

Let’s go back to March 2020, when COVID-19 first shocked the Western world. If I had predicted, “A company will develop a vaccine and ship 50 million units by the end of the year,” I would have been called crazy! No vaccine had ever been developed in that kind of timeline.

So why did Pfizer’s stock price drop so much when they announced in December that they’d ship 50 million units by the end of the 2020?

It’s because they had earlier promised 100 million units, and that promise had been priced in to their stock. “Good news” is all relative. “50 million units” is phenomenal compared to our March 2020 assumptions. But “50 million units” is disappointing compared to the promise of 100 million units.

We frequently see this pattern in the stock market. “Good news” can make stocks go down. “Bad news” can make stocks go up. “No news” gets interpreted a million different ways. It’s all relative, and all depends on what news has already been priced in.

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The Keynesian Beauty Contest

Up to this point, we’ve only thought about fundamentals getting priced in to an asset price. Future revenue, future profits, future production, etc. These are all metrics that affect a company’s intrinsic value and their potential dividends. And those metrics get reflected in the stock’s price.

But there’s also a psychological component to the stock market. It’s game theory. Specifically, it’s the thought process, “Screw my opinion. How will everyone else react to this news? How will ‘Mr. Marketreact?”

To explain this idea, famous economist John Maynard Keynes created (in 1936) the “Keynesian Beauty Contest,” a game theory/psychological metaphor that remains useful in describing markets today.

Alive in the long run - The enduring legacy of John Maynard Keynes | Books  & arts | The Economist
John Maynard “The Mustache” Keynes

Keynes asks you to imagine a newspaper beauty contest with 100 contestants. You can act as a judge by writing to the paper and picking your top six most attractive faces. If you pick the most attractive faces, you win a prize.

At first blush, your job is easy. Who do you find attractive? Pick your six and your job is done. Maybe you’ll win the prize.

Keynesian Inception

But then you pause. You really want that prize. Does your strategy make sense?

No, your strategy doesn’t make sense. Instead, you realize, you’d be better off thinking, “How do others judge beauty? Who would they pick as their six most attractive faces?”

You should pick a new set of six faces based on your views of the group’s judgment.

But then you pause again. Perhaps everyone else has already priced in the group’s judgment into their choices!

Individual opinion was Level One. And your views of the group’s judgment was Level Two. Instead, you should now ask, “What does everyone else think about how everyone else thinks?” That’s Level 3.

It quickly gets confusing, a layered onion of opinions about opinions.

This is how Keynes described the stock market, and he’s largely been proven correct. Some people buy stocks not because of fundamentals, but instead because they think other people want the stocks.

Human psychology gets priced in.

Sports Betting, Sports Drafting

There are two terrific analogies of the “priced in” phenomenon from the world of sports.

Sports Betting

Let’s say everyone’s favorite Buffalo Bills just beat the evil New England Patriots by a score of 31 to 20. And yet, in this hypothetical, people who bet on the Buffalo Bills lost their bets? (Trust me, it’s my hypothetical!) How can this be?!

Buffalo Bills GIF by NFL - Find & Share on GIPHY

A betting line is a form of gambling where the bookmakers set a handicap that changes a contest’s probability to approximately 50/50.

In my hypothetical scenario, the bookmakers handicapped the Buffalo Bills by 15 points. That’s how good they think the Bills team is. Via this betting line, the Bills’ skill has already been priced in to their performance.

So when the Bills win by “only” 11 points, it’s disappointing news relative to how good the bookmakers thought they were. They were supposed to be 15 points better. The Bills team is happy, the Bills fans are happy, but Bills bettors might be unhappy. The Bills weren’t quite as good as they had hoped.

This is parallel to news being priced in on the stock market.

Sports Drafting

I remember being so confused as a 12-year old basketball fan. Why do NBA teams draft untested high school players ahead of seasoned, proven, talented 22-year old college seniors? The 22-year old is clearly the better player, I thought.

But I was wrong. The 22-year old is the better player right now. And focusing only on present talent is an important distinction between 12-year old basketball fans and professional basketball scouts.

When NBA teams draft an 18-year old high schooler, they have priced in his future growth. By the time he is 22, they believe he’ll be better than the 22-year old college player is right now (and potentially better than the 22-year old will be when he’s 26). The college player has a better past performance than the 18-year old. But the NBA cares about predicting future performance.

It’s easy to confuse past performance with future performance. Let’s look at Apple. Their stock is high because they’ve been leading consumer computing hardware for 15 years—right?

Wrong. Sure, the past 15 years of performance give us confidence that Apple can maintain their leading position into the future. But Apple’s price is based on predictions about their future, not on results from their past. The future gets priced in. The past is only useful insofar as it informs that future.

Why is the Stock Doing X?!

I hope the concept of future events getting “priced in” helps you better understand the stock market. Many exasperated questions—why is the stock market going up?! down?! sideways?!—are answered through this lens.

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