Discounting Mechanism

What Is a Discounting Mechanism?

A discounting mechanism operates on the premise that the stock market essentially discounts, or takes into consideration, all available information including present and potential future events. When unexpected developments occur, the market discounts this new information very rapidly. The Efficient Market Hypothesis (EMH) is based on the hypothesis that the stock market is a very efficient discounting mechanism.

How a Discounting Mechanism Works

The discounting mechanism principle is used to describe a key characteristic of the stock market. This principle essentially states that the stock market accounts for certain information or news events. Therefore, people and companies who take part in the stock market adjust positions and prices by considering events that may take place in the future. This explains the wild swings in stock indexes following unexpected events such as a natural disaster or a terrorist attack. Just think about how rapidly an earnings miss for a company will move an individual stock.

One of the basic tenets of this principle is that the stock market generally moves in the same direction as the economy. So when the economy grows, there's a good chance the stock market will also show gains.

By contrast, if there's a downward trend in the economy, there is a chance the stock market will follow suit. The market may even rise when there's an expectation of economic growth. Investors witnessed this when the stock market crashed following the financial crisis in 2008.

As noted above, this principle is based on the EMH theory. Share prices are believed to reflect all information and trade at their fair value on exchanges. This makes it impossible for investors to sell stocks at inflated prices or buy them when they are undervalued. This would make it next to impossible for anyone to outperform the market through technical or fundamental analysis. Investors would have to turn to high-risk investments in order to generate better returns.

The efficiency of the stock market as a discounting mechanism has been vigorously debated over the years. In an attempt to show that equity markets do not always get it right, economist Paul Samuelson famously remarked in 1966 that "Wall Street indexes predicted nine out of the last five recessions."

The discounting mechanism theory suggests that when the economy grows, there's a good chance the stock market will also show gains.

Criticism of the Discounting Mechanism

Just because the stock market and the economy have shown a direct correlation in the past, that doesn't mean they always move in the same direction. In fact, there have been cases that presented the opposite scenario. Investors didn't believe or bother to consider the potential pitfalls of prior stock market bubbles, even though there was so much buzz.

For example, the dotcom bubble — based primarily on speculation — saw a rise in technology companies. Many of these companies were startups and had no financial track record. Money was cheap, so raising capital was no problem. Some economists believed this to be a new normal or new type of economy, in which there was no possibility of a recession or inflation — despite warnings from Federal Reserve chair Alan Greenspan, who suggested that these theories were not rational. The bubble burst after the Fed tightened its monetary policy in 2000, with the market crashing and losing all the gains made during the late 1990s.

Because of its less-than-perfect record as a reliable discounting mechanism in all situations, many people contend the stock market is a lagging reaction to economic changes. The bottom line is the future is capricious, which is partially why markets exist in the first place. If the future was predictable, there would be no reason to compile differing views of supply and demand for goods and establish market-clearing prices. This means there would be no need to create markets. There would only be the "price preeminent" — an omniscient price that represents the market-clearing price, not just for current supply and demand, but for all time.