2 Reasons the Stock Market is Not Overvalued.


 

Most of the time, the stock market moves up and down in seemingly rational ways.  Good economic data is often met with a rise in the market, while bad news is followed by a downturn.  What we’ve seen so far in 2020 does not follow that logic; in fact for many it may seem like the stock market is completely untethered from reality.  In a year where a global pandemic has shut down many businesses and grinded our economy to a halt, the S&P 500 and NASDAQ have risen to all time highs.  The chart below shows monthly real GDP % change against the performance of these 2 indices over the last 3 years.  Up until late February, both of these measures climbed steadily, almost mirroring one another.  When the COVID outbreak hit, the market dropped right alongside the GDP in March.  But then something happened that it seemed most people didn’t expect.  The market recovered…fast.  Since the March 23rd bottom, the S&P 500 and NASDAQ have risen 46% and 52% respectively, taking them into positive territory for the year. Meanwhile GDP and employment numbers are still near depression levels.  So what gives?  Is the stock market just way too high?

The answer is not necessarily.  There are 2 primary reasons why it is not irrational for the market to be priced where it is:

1.) The S&P 500 and NASDAQ are NOT the stock market.  It’s easy to assume this if one just casually watches market news, but it is not the case. Each index is market cap weighted, meaning the larger the company, the more weight it holds.  The result is that both of these indices are largely driven by the returns of very large, US based companies (many overlapping). There are literally thousands and thousands of companies that make up the overall stock market that are not included or make up a nominally small percentage of their return.

Consider the graph below.  If you take the same 500 companies of the S&P, but just give them equal weights, the YTD return dips down to -8%.  Additionally, if you look at the returns of value stocks around the world, and small value stocks in the US, they are still down 16% and 23%.  Stating that the market is up on the year is more accurately stating that a small number of large US companies have done well and carried their respective indices.

2.) The stock market is forward looking.  The price of any stock is today’s value of all future income.  A common valuation ratio often used is PE, or price to earnings.  This number represents how much a company is worth relative to their earnings (net income).   Historically, the averages for this number have ranged from about 15 to 30.  It currently has been hovering around 25.  This means that companies are valued at 25 times what they’ve made in the current year.

Concurrently, many estimates suggest that the economy will perform at 60-70% of pre-COVID expectation this year, and that it will slowly work it’s way back to full output over the next couple of years.

Combining these ideas in a simplistic example, pretend one has an asset that was expected to generate 25 equal cash flows and it was priced accordingly.  However, something unexpected happened and the first cash flow was reduced by 35%, and the next couple cash flows were also reduced by a lesser degree, but numbers 4-25 remain unchanged. How should that impact the price of the asset?  Should it drop 35% just because the first cash flow dropped by that amount?  Of course not.

This should be generally how we value the stock market.  Of course some companies/sectors were more resilient to this market, while others may have to shut their doors forever.  But when valuing the aggregate of all companies, short term disruptions to earnings should not drastically impact the price of a market, which is essentially what we’ve seen from this market over the last few months.

1 Comment

  1. Edward Russ on August 1, 2020 at 3:27 pm

    Thanks for the articles Kenny. Explanation was great.

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