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The Emperor Has No Clothes!

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Proponents of the Efficient Market Hypothesis argue that at any given time, the stock market accurately adjusts stock prices to their appropriate value after taking all available information into consideration. I think this is a load of bull. Rather than accurately reflecting all available information in a company’s stock price, I believe that the market merely prices in the emotions of the herd. Let’s take a look at some examples.

Apple (NASDAQ: AAPL) is a perfect example of an entirely inefficient market. In September of 2012, Apple held the title for largest company in the world, sporting a market capitalization just over $600 billion. You couldn’t read a newspaper or financial magazine that was not talking about Apple and its meteoric rise, not to mention claims of it becoming the first trillion dollar company. Despite all the hoopla coming from the talking heads on television, Apple management had already suggested that margins would be lower than in the past and projected earnings were lower than Wall Street’s expectations. Rather than price in the new information, the market was pricing in the extreme optimism for the company’s future, completely ignoring the guidance from Apple management. One explanation may lie in the fact that, historically, Apple management has given very conservative guidance in terms of earnings, proceeding to blow-out expectations on the date of earnings release. But you and I both know that the past is no guarantee for the future, and the market should have heeded management’s warnings. The chart below shows the result of the market’s so-called efficiency.

<img src="http://media.ycharts.com/charts/bd7d5723d38ffd99e7975507fe8cd622.png" />

AAPL Market Cap data by YCharts

Netflix (NASDAQ: NFLX) has been on a similar ride as Apple, but is simply in a different stage at this point. Reaching a high in the low $300 range, Netflix was slammed after a number of management gaffes which sent the stock price into the $50 range, a multi-year low. Is it a mere coincidence that Apple was reaching its all-time highs in that very same month? I think not. The pessimism priced into Netflix shares conflicted with the guidance given by company management, guidance which has been accurate for 24 of the last 28 quarters. At the same time, the enthusiasm priced in to Apple shares conflicted with the lower guidance being given by Apple management. I think this portrays perfectly the way the stock market works: it prices in emotion instead of information. Take a look at the chart below and see what happens when those emotions change.

<img src="http://media.ycharts.com/charts/4b40b367758a85728ad40ae403b6e231.png" />

NFLX Market Cap data by YCharts

I think the Herbalife (NYSE: HLF) story shows how the market is not only inefficient, but can be easily manipulated. Bill Ackman’s short thesis for Herbalife can be found here, and you will see that it does not have any information that was not already available to the public. Despite that being the case, the market sent shares of Herbalife tumbling after the presentation was made. If the market was actually efficient and reflected all available public information, why would there be the need to reduce the share price? What makes this story more interesting was the subsequent rise in Herbalife shares after Daniel Loeb of Third Point LLC announced an 8.2% stake in the company. The drop and subsequent rise tells me that the market does not know how to weigh the information that it is being presented with, meaning that it cannot possibly be efficient.

Where it gets even better is that these big players have the ability to manipulate the price of Herbalife’s stock. With Mr. Ackman being short and eventually having to cover, big players in the market can take advantage of the situation by buying up large amounts of stock, therefore reducing the shares outstanding. This would make it harder for Mr. Ackman to repurchase the shares which he borrowed. Taking it a step further, a group of large shareholders can pressure the company to issue a large dividend or share repurchase program. In the case of a large dividend, Mr. Ackman would be forced to pay that dividend to those from whom he borrowed Herbalife shares. In a situation like this, do you think the market is being efficient? I certainly do not.

When I think about whether the market is being efficient or not, I cannot help but think about Amazon.com (NASDAQ: AMZN). Over the last few years, Amazon has continually plowed its earnings back into the company, investing in new distribution centers around the country. With the amount of capital expenditures being made, the company has reported low earnings numbers. With market participants enthusiastic about the company’s future, shares currently trade at just under 3,800 times earnings and 108 times free-cash flow. Check out the charts.

<img src="http://media.ycharts.com/charts/0fccb14bd301000f24b1d3fe58217692.png" />

AMZN PE Ratio TTM data by YCharts

<img src="http://media.ycharts.com/charts/b7f25e7b3e87a8b346d3e6393547885b.png" />

AMZN Price to Cash Flow TTM data by YCharts

 The enthusiasm pushing the share price higher makes me wonder if the market is being inefficient again, pricing in emotion rather than information. Only time will tell, but I can’t help but think that when the tide goes out, Amazon might be the one not wearing any clothes!

A lot of investors try to separate companies into different categories: value, growth, stalwarts, etc. Unfortunately, the stock market is a complex system that cannot be viewed as a linear equation. What makes Company Y a value stock does not necessarily make Company Z the same thing. Unless the market’s crystal ball works better than mine, predicting the future is a fool’s task. It is for that reason that the market cannot efficiently price a company and resorts to pricing based on investor's emotions instead.

RoyalScribe owns shares of Netflix. The Motley Fool recommends Amazon.com, Apple, and Netflix. The Motley Fool owns shares of Amazon.com, Apple, and Netflix and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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