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Author: captainccs Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 41634  
Subject: Wall St. Discounts Date: 1/23/2007 5:48 PM
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I find it important to understand how time affects stock prices specially because Wall St. tends to "discount" news. The term discount is applied to loans where the interest is taken off the top. Say you borrow $1000 at a 5% discount, the bank takes $50 of the top and gives you $950. (Of course, your real rate is higher because you never saw the $1000. In effect you are paying 5% on $950, a real rate of 5.26% -- but that's not the issue here).

Wall St. does something similar with "news." Wall St. has the tendency to anticipate events and to change the price of securities accordingly. This is called discounting the news. Of course, this does not apply to real news because no one can forecast real news. It only applies to non news that masquerades as news, i.e. most of what is published in the financial press. Let me use the US housing bubble as an example.

The housing bubble started sometime in 2001 and must have reached its peak when it make the cover of Time Magazine on June 13, 2005.

http://en.wikipedia.org/wiki/United_States_housing_bubble

Have a look at DR Horton Inc. (DHI), the largest home builder in America, its stock price climbs in unison with the housing boom:

http://finance.yahoo.com/q/bc?s=DHI&t=my

Once the world is alerted to the fact that housing is in a bubble, people start to sell DHI because they know that bust follows boom. By August 2006 DHI has been cut in half and the two year chart clearly shows the bottom in DHI:

http://finance.yahoo.com/q/bc?s=DHI&t=2y&l=on&z=m&q=l&c=

But the housing bust had not bottomed yet. Even now there are discussions about whether the housing market has seen the worst or not. So while the housing market is still in decline, the home builders have started on the way up 4 to 6 months ago. That is discounting the news. Investors know that the housing market is still on the way down but, since they beat the price of home builders down ahead of time (discounted the news), they can start bidding up the home builders ahead of time discounting the news that the bust must soon see the bottom.

Today there was in interesting piece of confirmation to all this. DR Horton Inc. reported earnings down 65%:

BOSTON (MarketWatch) -- D.R. Horton Inc., the nation's largest home builder, said Tuesday that net income fell about 65% as the company took land charges and write-offs on options it plans not to pursue.

The Ft. Worth, Tex.-based company became the latest residential builder to announce a decline in quarterly profit as well as land-related charges as the housing and real-estate markets soften.


So what happened to the stock price? Did it drop? NO, it advanced 4.57% to 28.37! The only reason this can happen is because these so called bad news are not news at all, the market knew all about it back in August 2006 and baked it into the price back then. The market discounted the news.

The financial press has to print non-news and call it news because the company made official what the market figured out 4 to 6 months ago. This is called "discounting the news."

Denny Schlesinger
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