We’ve basically had a full blown bull market since the market bottom in March. The S&P has a positive 34% return in just two months. How does that make any sense at all? Unemployment is higher than any time since the Great Depression. The death toll from Covid-19 continues to climb slowly, and everybody still says that a vaccine is a year away at least. What gives? It seems like the market has become completely disconnected from reality.
What is the difference between the stock market and the economy?
The first thing we all need to understand is that there is a big difference between the stock market and the economy. And this distinction is NOT a new Covid-19 related phenomenon. The value of the stock market at any given time is the market's consensus opinion as to the present value of expected earnings of publicly traded companies. Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return.
This means that the stock market is concerned with the overall future profitability of publicly traded companies. It's literally that simple. Nothing more or nothing less than that.
That being said, unemployment only affects the stock market to the extent that it affects the future profitability of those publicly traded companies. For example, if unemployment goes up by 15%, that doesn't mean profits will go down by 15%. The actual change in expected profits could be greater or smalller than the change in unemployment.
Important considerations to that point would be:
- How long will the elevated unemployment last? (the shorter it lasts, the smaller impact on profits.)
- Which jobs are being lost? (Right now the majority of jobs lost have affected disproportionately lower paying jobs.)
The second thing to understand is that the stock market valuation is based on expected value of earnings.
The easiest way to understand this concept is to imagine a company that is undergoing a massive lawsuit. If the suit fails in court, the company would be worth $100 billion. But if the suit succeeds, the company will be bankrupt. Given those facts, what is the company worth right now?
That depends on the likelihood of the suit succeeding. If the suit has a 30% probability of success, the company should be worth $70 billion right now (that is, 70% chance that it ends up being worth $100 billion, 30% chance it’s worth zero). If the suit has a 50% probability of success, then the company should be worth $50 billion right now. As the apparent probability of success of the lawsuit changes, the firm’s value will change.
What Will The Market Do Next?
In simple terms, no one knows that answer. When Covid-19 hit millions of deaths were considered a possibility. No one knew what to expect because, we hadn't really seen anything like that before. Now we know that the probability of millions of deaths is a very unlikely scenario so we've seen the market rebound dramatically because the market is assuming that the worst of this is behind us now.
Is a Recession Imminent?
According to the National Bureau of Economic Research (NBER), a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales. The quick answer to this is more than likely yes we will experience a recession by definition, but I wouldn't let that steer my investing or retirement decisions.
Hope this sheds some light on the craziness of the stock market right now.
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