Does the Stock Market Reflect Reality?
Whether the stock market reflects reality is a million dollar question. If you can accurately decide if the stock market is over or under pricing a stock on a regular basis, you'd stand to make millions of dollars buying underpriced companies and shorting overpriced companies.
The Day to Day Basis
On the day to day basis, it's unlikely that the up and down prices represent reality in any form. Should Yahoo be worth $20 million more at 10:30 AM than it was at 10:25 AM with no critical pieces of information released? No, of course not, but the market will run the course however it decides. On the day to day, the stock market rarely reflects reality; businesses simply should not rise and fall in value by billions of dollars on small news events. Should a strike at a GM plant drop the company's worth by one hundred million? Probably not, but day traders can make it happen.
Foresight to Know True Value
To know the future value of a company's stock would put you in the category of the best investors of the world. Investor Warren Buffett has made his billions buying stock in companies he decides are undervalued - only to sell them when the market sees it the same way. His skill to find undervalued companies and hold them until they are properly valued is a talent that continues to provide impressive results for his shareholders.
Two Schools of Thought
Investors who use technical analysis would say that the stock market always reflects reality because the worth of a company is only what someone is willing to pay. Technical analysts assume that the current price reflects all of what is known about a company at the present time and is always a good valuation of a particular stock. Fundamentalist investors would argue that the price of stock should depend on its underlying business. If business is doing well, then so should its share price.
If it's possible, both schools of thought might be right. Technical investors virtually exclude all market events and instead profit off the changing prices - not the changing business climate. Fundamentalists look to buy good businesses for cheap; it's easy to see how they would think that the stock market does not reflect reality.
Over Time, the Market Perfects Itself
Over long periods of time, the free markets always perfect themselves. Look back to the beating tech stocks took at the beginning of the new millennium; they eventually fell to PE ratios that were in line with the rest of the market. If you had known at the time that tech stocks were overvalued historically, it would have been possible to pull returns now unimaginable.
The long term look is always the most rational. More data, more trading and the law of averages suggests that in the long term, all assets will be properly valued. This could either be from one of many reasons: investors become happy with a standard price, or the worth of something is only what investors are willing to pay. No matter what answer, knowing when stocks are properly valued is a skill worth a million bucks - literally.