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Understanding when something is “priced in”

By August 12, 2020 No Comments

I recently wrote that a Biden victory in November isn’t likely to tank the markets. One of my arguments is that the market may have already “priced in” a Biden victory. But what does this actually mean beyond the lingo? Simply put, it means the market has anticipated a future event and the potential ramifications of the event are already reflected in the current price of the market. It’s a very important concept to understand, so let’s dive in further. To start, let’s introduce the idea of known risks versus unknown risks.

Known vs Unknown risks

The upcoming election is a known risk: the market knows the date it is happening and it knows the potential results: either Biden or Trump will win. Therefore, the market takes that information and it gets “priced in” to the market’s current price. While it’s impossible to know who the market wants to win or thinks will win, it’s unlikely any result of the election will really catch the market off guard. After all, there are only two possible outcomes.

This also helps explain the significant down move we saw earlier this year. The Coronavirus pandemic and government-induced shutdowns came out of nowhere. They were unknown risks, giving the market very little time to price in the ramifications. The result was a ‘sell now and ask questions’ later type of moment leading to the fastest downturn in market history. The election outcome isn’t likely to cause a similar reaction because it isn’t an unknown risk.

But what about a second wave of the virus and more shutdowns? Well, much like our election scenario, this is something that’s already out there. In other words, it’s a known risk. And known risks tend to get priced into the market, at least to some extent. So if the market were to make a dramatic fall again, it’s very likely going to be because of something no one sees coming; an unknown risk.

Examples of “priced in”

The best way to further explain the concept of something being priced in is to highlight some examples:

  • The S&P500 had one of its best months in the last 20 years in April 2020 even as the unemployment rate started soaring. The market likely “priced in” the grim unemployment situation during the March sell-off. So when the official data started coming out in April, as bad as it was, it was already priced in and maybe not as bad as expected.
  • Apple stock typically goes higher ahead of new product launches only to then flatten out after the product officially hits the market. This type of pattern is an example of the market pricing in the excitement of the new product before it ever becomes available for sale.
  • The US 10 year Treasury yield has been near historical lows since March. The persistently low yield is a sign the market has already priced in what the Federal Reserve says will be a low interest-rate environment for a long period of time.
  • Every earnings season there is a company that posts earnings that “beat” Wall Street expectations, and yet the stock sells off anyways. What’s happening here? The earnings beat was already priced into the stock price.

One of the most classic examples of something being priced in could come when there is finally a COVID-19 vaccine available. There’s no doubt that optimism around a potential vaccine has contributed to the stock market’s rally in the last few months. I wouldn’t be surprised if on the day a US company, like Moderna, finally announces its COVID-19 vaccine is ready, that the stock market actually sells off.

How to know if something is “priced in”

The idea that something is priced in does not imply that the market always knows what will happen. It’s more about the market being aware of what could happen. Unfortunately, the only way to know for sure if something was priced into the market is for it to happen. Once it does, then you can judge the market’s subsequent reaction. For example, if Biden did win the election and the market then tanked 10% in the days after his victory, we would say him winning was not priced into the market. Can you tell if something is priced in before it ever happens? No. But you can spend hours debating it, and fools like me even dedicate time to writing about it.

If you spend enough time watching the market, you’ll no doubt be surprised by what you see along the way. Perhaps its a company shrugging off a poor earnings report, or the stock market rallying on a weak jobs number. In many cases what you are seeing is market reactions to information that was already priced into the current price. Remember, most known risks are already priced into the market. The biggest negative market reactions occur when an unknown risk pops up and the market struggles with pricing it in.

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