On Wall Street, there are two big schools of thought in determining what a stock is worth. The first is that a stock is worth the future corporate profits that the share will bring to its owner. If there are 100 shares in a company, and the company will make $100 in profits this year, and none after that, each share is worth $1 (not including discounts for time and risk). This is the number crunchers approach, and is the one that I usually write about when applying financial principals to HSX stocks. If a stock will delist today at $10, it is worth $10. You should be aware, however, that this approach does sidestep a fundemental principal of economics.

When economists are asked what something is worth, their usual response is “whatever someone is willing to pay for it”. This same principal applies to HSX as well. If you know demand will drive this same $10 stock up to $15, then the stock is worth $15. If you know a stock, due to trader psychology, will stay underpriced until it opens and adjsuts upward, then the stock isn’t worth the adjustment price until just before it adjusts. This behavior occurs on Wall Street constantly. Companys’ stocks routinely sell at prices well above what projected company profits would dictate, because tbuyers are convinced that they can find “a bigger fool”, someone who will buy the already overvalued stock at a higher price. It is also what many Wall Street analysts say was occuring prior to the stock market drop a few weeks ago. This is why it isn’t my primary stock buying strategy. It also is at odds with econmics, since it is irrational.

Economics makes the assumption of rational markets, meaning that people don’t do things that are against their interest. they don’t deliberately buy high and sell low, and they don’t buy stocks for more than they are empirically worth. Now, economists aren’t stupid. They are well aware that people aren’t always rational, but they observe that rationality is still a very reliable predictor of human behavior, particularly when looking at large numbers of people interacting, like in a stock market. In the long run, despite bouts of irrationality, well performing companies see their stock price rise higher and faster than companies that perform poorly. When Wall Street stocks stayed overpriced for too long, a brief panic eventually brought their prices back into line.

HSX works even more efficiently. An HSX stock, unlike a Wall Street stock, has a publicly known day of reckoning, where it is forcibly cashed out. Those holding an overpriced stock will eventually see the price tumble, and those who hold an underpriced stock will eventually see their profits. Thus, assuming rationality on the HSX, even though we know the HSX market has huge bouts of irrationality, is still a pretty damn good strategy. Relying on purchasing undervalued stocks and selling them when they become overvalued is a pretty fool proof system for doing well on the exchange.

However, this does not mean that predicting irrational behavior is a bad idea, its just dicier – there is no guarantee that an irrational purchasing decision will turn a buck, unlike a rational decision. But when patterns show themselves, it can be smart to take a gamble and “ride a rollercoaster” (I, and many other traders I’m sure, made a bit of money last week continuously buying MADCI at $9.3 and selling at $9.7), or hold a film you think will become even more overpriced due to HSX demographics, which tend to drive up the price of science fiction and action movies.

Since predicting the mass psychology of the HSX market is very difficult, and fraught with peril, I will continue to focus my writings on rational purchases, but we will make the occasional foray into the Twlight Zone of irrationality.

Rod Serling out.

Tom Miller