The Used Car Market Is More Efficient Than The Stock Market – Seeking Alpha

This post was originally published on this site

By Rob Bennett

There was a time when I did not feel comfortable negotiating a price when buying a used car (I have never purchased a new car). A friend of mine told me how much he enjoyed doing so. He researched prices before going to the dealer, so he knew in advance how far he could push for a lower price before going too far and losing out on the deal altogether. He saw it as a game, had fun doing it, and usually ended up getting great deals.

He convinced me to give it a try. Once I did, I was hooked. It is fun to negotiate, especially when you calculate how much money goes into your pocket for each hour of time you spend researching in preparation for the negotiations. The cool thing is that the dealers are perfectly happy with the deals they do with serious negotiators too. They make more money from buyers who do not do their homework. But they wouldn’t close the deals with good negotiators unless there was a profit in it for them. So, they are winners too.

This is the magic of markets. Both parties to a deal end up winners. A deal with two winners sounds like something that could not exist, like a perpetual motion machine. But the reality is that the buyer is happy to pay the amount of money for the car he buys and the dealer is happy to sell the car for the amount of money he takes in, or else both would not agree to the deal. Deals made in well-functioning markets are the free lunch that Buy-and-Holders warn us so frequently does not exist.

The sad thing is that for Buy-and-Holders, the free lunch that they should be obtaining when they buy stocks really does not exist.

Buy-and-Holders believe that the market is “efficient.” An efficient market is one in which the market is doing its job of setting prices properly. All factors that should be considered in setting the price of the thing being sold are being considered. In efficient markets, the price is right.

That’s not the stock market. Not as it exists today. Stocks were priced at one-half of fair value in 1982. They were priced at three times fair value in 2000. They are priced at two times fair value today. It’s hard to remember a time when stocks were priced properly. The stock market is probably the least efficient of all the markets with which we are familiar.

Why?

It’s because of how we have been taught to think about stocks. Compare how most of us go about buying stocks with how most of us go about buying used cars, and it’s not too hard to see why the stock market is such a wildly inefficient market.

The used car dealers with whom I have negotiated have employed all sorts of trickery to get me to part with more money than I want to or need to part with to buy a car. They always want to know how much you can afford to spend so that they can take the focus off of the value of the car and onto the amount you can spend and then change the amount you can spend by offering credit, thereby getting you to spend more than you planned. And they tell you that they are giving you a special deal because you look smart and because there’s something about you that they like. And they warn you that there’s another buyer ready to sweep up the car you like if you don’t buy today. And they make you wait while they check with their boss, knowing that the more time you have invested in the deal, the less likely you are to walk away from it.

All of this is annoying. And all of it is a sign of great market efficiency.

It is these sorts of tricks by which a market achieves efficiency. The market determines the correct price by setting buyers against sellers. When the seller fights hard for his interests and the buyer fights hard for his interests, the correct price emerges. Why? Because when the seller is fighting hard, the buyer is forced to fight hard in resistance to avoid losing out on the deal, and when the buyer is fighting hard, the seller is forced to fight hard to avoid losing out on the deal. When both seller and buyer fight hard, they eventually end up in the middle of the two best close-to-right prices: the efficient price.

This is not how the stock market works. Have you ever heard stock investors complain about a price increase? It never happens. We cheer price increases. We applaud bull markets. We feel like we win when we lose. Many of us buy stocks with our bi-weekly paychecks, and we are happy when we learn that next week we will be paying more for each share than we paid last week.

In the stock market, both sellers and buyers act like sellers act in all other markets. So prices get wildly out of whack for long periods of time. Then the market crashes them, because there is no other way to bring them down. Then prices remain wildly out of whack on the low side for long periods of time. The market sets prices inefficienctly on both ends.

What would it take for the stock market to become as efficient as the used car market? We would need to start reading Edmunds before going out to buy stocks. The Edmunds of the stock world would tell us what the long-term return on stocks is likely to be when they are purchased at the valuation level that applies at that particular time. Demand for stocks would be greater when prices were good and softer when prices were poor, as is the case in efficient markets. With investors practicing self-discipline, market prices would become self-regulating. They would make sense. The stock market would achieve the efficiency that it is only imagined to possess today.

The great irony is that, if we educated investors as to why Buy-and-Hold doesn’t work, it would start working! In a world in which most investors exercised price discipline when buying stocks, prices would always be right and stocks would always be worth buying.

Disclosure: None.

SeekingAlpha