When most investors look at the terrible economic numbers and then look at the rising stock market, they think, this makes no sense. How can the economy be so bad, but the stock market be so good? In fact, the S&P 500 is roughly back to the high it reached at the end of 2019, when all was good in the world of finance.
While there seems to be a disconnect, the reality is the stock market does make sense. If you believe the nation will recover from the virus and the economy will get back to normal, then there is no reason for stock prices to fall. A rational investor will look through the bad current numbers to better numbers down the road. Currently, estimates for S&P 500 earnings show the numbers getting back to their pre-2020 highs by the end of 2021. So, if investors believe everything is going to be alright in 18 to 24 months, why should investors sell stocks?
Photograph by Ellen Jaskol
This is of course the message we have been getting from Warren Buffett for decades. You don’t sell stock in a good company just because it hits a temporary rough patch. You hold it for the long term, and its value is based on how it performs over decades, not a few months or years. Thus, it is perfectly rational for the stock market to maintain its value even in the midst of this recession. This is the message we are hearing from many on Wall Street, but that’s what makes me nervous.
In the long history of financial markets, investors as a group have never been rational. They have been primarily speculative. Their decisions drive boom and bust cycles, by dumping stocks in bad times and aggressively buying them in good times. Investors, particularly those who influence daily stock prices, have never fully “looked through” the cycles and invested rationally based on reasonable expectations for long-term growth.
For instance, a rational investor would not bid up stock prices 30% in one year just because things are going well that year. A rational investor would look at the long-term trend of profits and dividend growth and maybe pay 6% to 8% more a year from now. Conversely, a rational investor would not dump stocks in a recession because good companies get through recessions, and there is no reason to sell if you have a solid business that will recover.
So why all of a sudden are investors “looking through” the bad numbers and rationally assessing the future? Has human nature changed that quickly? Is Wall Street now only going to make rational investment decisions and promote rational pricing? We have to consider the possibility. Maybe Wall Street has learned this lesson and is finally taking Mr. Buffett’s advice.
To have confidence in this new assessment of investor behavior, we’d probably have to go through three or more recessions without any significant price declines. And we’d need to go through three or more good cycles, without crazy price increases. If we did that, then we could have more confidence that investors are looking through cycles and investing more rationally based on long-term growth and profit trends.
Because we can’t know how investors will react to the next three market cycles, we have to make some assessment about what’s actually happening today. Are investors really looking through to the recovery, so no matter how bad the numbers get, the market will hold up because eventually the economy will recover? Are we done with bear markets? I doubt it.
The odds are that this brief period of market rationality is simply a byproduct of massive Federal Reserve and Congressional support for a struggling economy. The traders who drive short-term market values are evaluating that support on a daily basis. They have never “looked through” booms or busts before, so I doubt that they started today.
This thin veil of rationality being promoted by analysts and other market commentators could be pierced by one bad press conference from Jerome Powell. If traders get the sense that the support may wane or may not be enough, they are unlikely to look beyond that day’s closing bell. The Fed says they will do whatever it takes, but keep some dry powder and safe money on the sidelines, just in case the Fed changes its mind. Markets aren’t fully rational yet.
Charlie Farrell is a CEO of Northstar Investment Advisors LLC. This article is for information and education purposes only. Past performance is no guarantee of future returns, and all investing involves the permanent risk of loss. Consult your individual financial adviser for guidance specific to your circumstances.