So, what is short selling?

Short selling is the sale of something that you don’t own.  It’s most often associated with the sale of common stock.  You’ll hear on TV reports about a “short squeeze,” or that the shorts are hurting.

The Efficient Market Theory (also referred to as the Efficient Market Hypothesis or The Principle of Capital Market Efficiency) is expressed in many ways, but one of the more common is that “all available information is reflected in the price of a stock.”  The idea is that no one has an advantage.  The minute something is known about a company, in fact the very nanosecond, the price of its stock and the value of its bonds adjust instantaneously to reflect this new knowledge.  Securities—stocks and bonds—are always fairly priced.

Most of us simply don’t believe this theory.  I don't.  I like the concept a lot, but personal experience leads me to believe that its a theory that's not fully formed.  For one thing. If it’s true, why did stocks adjust so precipitously in October of 1987?  In the US the markets are as efficient as markets can be; however, there does seem to be an element of the irrational every now and again.  The stock market seems to be efficient in the long-term and pretty wacky in the short run.  It was Benjamin Graham, Warren Buffett's mentor, who said that in the short term, the market is a voting machine; while in the long term, it’s a weighing machine.

Why do stock prices plummet if earnings dip slightly?

I delayed addressing this topic until we’d been through a bit of a numbers-fest!  I talked earlier about money managers.  In many cases, money managers have models for the financial performance of companies.  Just as we will do in chapters 2 through 5, the models seek to learn the future, often using information learned from behavior in the past.  These models are based on earnings or more likely free cash flow.  In summary, free cash flow is the amount of cash you could extract from the business each accounting period without affecting its operations.