Road to Retirement: The stock market makes sense, and that makes me nervous

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 JaskolCharlie Farrell

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 …read more

Source:: The Denver Post – Business


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