What is Discounting Mechanism

Discounting mechanism is the premise that the stock market essentially discounts, or takes into consideration, all available information and 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.

BREAKING DOWN Discounting Mechanism

The fact that the stock market is essentially a discounting mechanism explains the wild swings in stock indexes following unexpected events such as a natural disaster or a terrorist attack, or an earnings miss in the case of an individual stock. The efficiency of the stock market as a discounting mechanism has been vigorously debated over the years. Economist Paul Samuelson, attempting to show that equity markets do not always get it right, famously remarked in 1966 that "Wall Street indexes predicted nine out of the last five recessions."

Stock Market as a Discounting Mechanism: The Debate

Most of the time, the stock market and economic trends seem to be on the same page. For instance, between 2003 and 2007, anticipation of further economic growth led to a rise in the stock market. Investors’ expectations were fulfilled. In 2008, the decline in the stock market was equally accompanied by an unraveling of the financial system and a plunge in economic activity.  

However, there is a big difference between the market and economy moving together most of the time, versus all the time. The stock market will not always work perfectly as a discounting mechanism. In fact, disharmonies between the stock market and the economy have occurred at some of the most critical junctures in economic history. In early 2000, as the NASDAQ soared above 5000, most investors believed a “new normal” had been established. In October 2007, the stock market recorded a new all time high, as investors were confident that a recession would not develop and that the Federal Reserve was correct in its sanguine view of the housing market. However, the economy had different ideas with as the dot-com bubble and the housing market crash unexpectedly dropped the bottom out of the market in both instances.

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. Were the future predictable, there would be no reason to aggregate differing views of supply and demand for goods and establish market clearing prices, i.e. 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.