There is a huge disconnect right now between the broader economy and the stock market. Stock prices typically should reflect the relative health of the economy.
So with an ailing economy officially in recession territory why is it then that stock prices are well above what they should be given the health of the economy?
Theoretically, a stock’s price should reflect the sum total of all its future dividend payments when discounted back to their present value.
In other words, the price should reflect the net present value of all its future earnings. That’s how a stock’s price should be determined “in theory.”
In the real world, the most common stock valuation method is the price/earnings ratio or PE. The stock’s price is a multiple of its earnings (profits).
Suppose a stock sells for $5 a share with earnings of $1 a share. It has a PE of 10. According to a recent article in the Washington Post. historically, the PE for the entire U.S. stock market is about 15. But today’s market PE is hovering around 23, which is about 50 percent higher than the historic average.
In layman’s terms, there is something completely out of whack with the stock market and anybody who has a stake in it should be worried.
According to the PE valuation method, the stock price of a company like Hertz, which has declared bankruptcy, operating in the red, and also publicly declared that there is little hope of recovering should be worthless. Despite all logic, Hertz share price is trading above $1.
There are all kinds of explanations for high stock prices.
One of those theories involves the Federal Reserve’s policy of holding short-term interest rates near zero. Low-interest rates mean low yields on fixed-income treasuries, which is pushing investors into riskier financial assets like Hertz and Chesapeake Energy, which have both filed for bankruptcy but have also experienced recent surges in demand for their stock despite basic economic fundamentals that should scare away most investors.
In the same Washington Post article, William Silber, a retired financial historian at New York University has a more interesting and plausible take on what’s going on with the stock market. He points to the Great Recession to explain what’s happening today.
In 2008 when Lehman Brothers went bankrupt, it set off a selloff that launched the Great Recession. The S&P 500 fell by 45 percent by mid-March 2009, but by the end of 2009, the stock market had recovered almost all its losses.
According to Silber, many investors who lived through the Great Recession vowed not to miss out again on the sort of profit-making opportunity that occurred in 2009. Many vowed that when stocks tumble again, these investors will double down and fortify their stock positions.
FOMO or the fear of missing out may very well be driving the current irrational stock prices. FOMO along with herd behavior are rational explanations for recent market volatility that has included three separate periods of surges and declines: a 3 percent increase from January 30 to February 19; a 34 percent decline from there to March 23; and about a 40 percent rise from the end of March until now.
Other factors are also at play including the surge in mobile trading especially on commission-free platforms like Robinhood.com that has fueled a huge surge in trading by young and inexperienced traders who – bored-stiff from the COVID-19 quarantine and social distancing – are trying their hands at the stock market for the first time.
With no discipline and a penchant for risk, these noobs (newbies) are snapping up high-risk stocks like they’re going out of fashion.
If history has taught us anything, it’s that the stock market will eventually come crashing back to earth when stock prices finally reflect economic reality and the reality is things will probably get worse before they get better.
The unemployment rate is projected to rest at 11.3 percent by the end of 2020 with the GDP predicted to fall to 7.3 percent for the year.
Both the unemployment rate and the GDP decline are larger than in any previous post-World War II recession. For comparison, peak unemployment during the Great Recession was 10 percent.
FOMO is not an investment strategy. Its irrational human behavior has nothing to do with building value or wealth. This is exactly why the ultra-wealthy have fled the public markets. In fact, the ultra-wealthy started liquidating their equity starting in June of last year – well before the coronavirus was a blip on anybody’s radar.
The ultra-wealthy never invest based on FOMO. They invest in private markets where prices truly reflect the productive value of an asset.
In the private markets where investments are illiquid and as a result, insulated from herd behavior, the price of an interest in the business closely mirrors the expected future returns from that business.
The same goes for commercial real estate. The value of an investment in a commercial asset will reflect the discounted value of the future cash flow and appreciation from that asset.
Savvy investors are disciplined and play in the sandbox of other disciplined investors who invest for the long run. They invest in ROI and not for FOMO or any other speculative reason.
Where do you fall on the investment spectrum?
Don’t forget the fundamentals and ignore the underlying viability of a business. Don’t be afraid to ask the right questions:
- Is it profitable?
- What are its long-term prospects?
- Is the industry recession-resistant?
- Does it have intrinsic value?
Asking these questions will help you steer clear of the Hertz’s and Chesapeake Energies of the world.
Looking for great investment options during the pandemic? Learn more about our upcoming investments here
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.