Stock Market discounting mechanism

The principle that the stock market basically discounts, or consider present information as well events and potential future information and events. When unexpected developments occur, the market discounts this new information very rapidly. The Efficient Market Hypothesis (EMH) is based on the hypothesis that the stock market is a very efficient discounting mechanism.

The productivity of the stock market as a discounting mechanism has been vigorously debated over the years but in my view its insight is very useful while doing technical analysis.

Here is the brief explanation for market discount mechanism in simple words.

Price movements in market are due to trend in market participant’s hope, fear, knowledge, optimism and greed. Some of these factors re expressed as current market price. Stock market almost consists of everyone with personal savings. Their money is directly or indirectly is in or out of the market. Investors and trader’s money presence as well as absence affect market and prices.

Economic indicators and market participants flow of funds decides major indices trend. A news or expectation related to economy affect market major indices and set there trends. Market take direction on expectations and reacts on actual outcome.

e.g. like if quarterly earnings outlook is expected lower than previous quarter. Market might start to fall before actual quarterly results gets out. And when they came out as expected then market might does not react as it is already discounted it. This is one example of market discount mechanism. Same pattern is true for individual stocks or any other free traded security.

This means investors and traders takes action and positions ahead of time. If company result expected weak then investors start dumping stocks before actual result. If results are bad than thought then it will accelerate the selling and more fall in stock price occurs. But in other circumstances like market bottom, sector bottom or end of downcycle, stock price will react positively on future hopes.

That why familiar saying is ,  “ sell on good news ” for example, company post good results but stock still falls. Because there might be no better future visibility or earning peak out.

In bear market, bad news hit twice on stock price but in bull market it sometimes get ignored. Reverse also true with circumstances.

This explains why stock markets peaks when economic conditions are strong and form bottoms when the view is most depressed.

Principle of discounting mechanism not only applies to stock market or equities, but true for any freely traded instruments but investors must keep in mind, market never discounts same thing twice. Stock market discount mechanism is useful for trading as well as investing.