The market's overvalued bias

Let's take a look at why most publicly traded securities are either fairly valued or overvalued by the market, and why there are so few undervalued opportunities.

The price of a security changes often, some being repriced several thousand times each day. Investors continually monitor price fluctuations with the most sophisticated technology, immediately identifying price momentum and valuation trends. As security prices move, momentum investors act to take advantage of the price direction continuing - extending and exaggerating the trend, while value investors act to take advantage of the valuation anomaly -returning the security's price to its norm.

The efficiency of this system of checks and balances works differently for rising and falling prices. Because of the inherent risks of shorting, most momentum investors are monitoring rising price trends while most value investors are searching for undervalued securities. The combination of these two situations provides an overvaluation bias in the market.

Let's examine the example of good news that comes out on a stock, raising its price. Momentum investors and technicians react by buying the stock, sending the price higher. Even as prices reach levels which value investors can clearly identify as overvalued, they are generally reluctant to sell the stock short, for the risks generally outweigh the benefits. If, on the other hand, a stock's price is driven down by bad news to a point of undervaluation, value investors are quick to buy in, reversing the price trend.

How can an individual investor use this to his or her advantage?

1. Be cautious about buying securities in a rising market. You will probably be buying into an overvalued situation. While that can continue for quite a while, it always ends badly.
2. Due to a more efficient correcting mechanism, finding undervalued securities happens very infrequently. If you try to make it happen too often, you'll find yourself with more risk and lower returns than you expect.

In our next article, I'll discuss how you can find those rarest of rare undervalued securities.

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