The Stock Market is Over-Valued

 I am writing as the S&P500 is at about 3700.

The talk is how crazy it is for the market to be so high when everything else is so bad. So let’s discuss some numbers and talk about this over-value thing.

In the past year, end of December 2019 to end of December 2020, the S&P went from about 3220 to 3700, an increase of about 15% in one year. That’s a good clip but nothing crazy if you look at average returns from year to year.

That one-year horizon is a little misleading. From end of December 2019 to March 16, 2020, it fell to 2386, a decline of about 26%. By July 17, 2020, it rose back to 3225 – roughly equal to what it has been at the end of 2019, clawing its way back, and clearly well above the low of about 2386. The increase from 2386 to 3225 was huge in percentage terms, but it is measuring change from a very low previous low.

The conclusion from these two points is that the value of the S&P now – at around 3700 -- is nothing crazy.

Okay, let’s move on.

Why isn’t the value still at 2386? If so many economic indicators are so poor right now, why isn’t the value of the stock market much lower?

The simple answer is that the value of stocks are indicators of expectations about business profits in the future.

There are lots of theories about stock prices. Stock prices are related to many things – inflation, interest rates, economic growth, US interest rates versus foreign interest rates, and the size of Tuna schools. Depending on which financial guru you read, she might emphasize one or more of the many causal indicators and convince you of what will happen next.

To me, all that is much too complicated. What is simpler and more important is a gut-level prediction about the future of the US economy.

The US economy is technically in a recession right now. So it is hard to see anything good in the future – but the truth is, that makes it even easier. Like when you get sick and lose a lot of weight. The best bets are that when you get well, you are going to gain it back.

The same goes for the US economy. It might have been true that when Covid was scarier, all we saw was an endless pit. No light at the end of the tunnel. As you can see through the stock price, we were very scared at least through last March. But after March, stock prices oscillated a lot around a slowly improving average value. The oscillations showed uncertainty but the average revealed optimism. And even now, as people lose their discipline and contagion expands, stock prices continue rising.

Why? Not because we observe great economic stats now in the US. Some stats have improved but the short-term economic outlook is anything but rosy. The longer term, however, does seem better. Whether it is because we know how to better handle shutdowns or because we believe in vaccines – more and more people see the economy muddling through for a while and then breaking out. There is optimism that we are getting a handle on what to do.

Add to all that an unprecedented amount of stimulus coming from fiscal policy, a promise by the Fed of zero interest rates forever, and sacks of personal savings ready to be spent by households -- and you have plenty of reason to believe the economy will recover. 

How long will it take before the economy gets back to normal? I don’t know. But when people buy stocks today, they are buying them because of what they think will happen in the future.

In stock markets, you make money by buying when prices are low and selling when prices are higher. Business sales and profits might be poor right now – but it is the expectation of those sales and profits in the future that drives people to transact today.

I don’t predict stock prices. But I do think that prices today are not necessarily greatly out of whack. Financial gurus can quote all sorts of ratios and reasons why stocks cannot possibly stay so high. But I say, look at one thing. Look at the expectations about the overall US economy out at least a quarter or three. As long as those expectations are optimistic, today's stock prices are not alarming. Enjoy them. Smile. Pet the pooch. Spend a little. 

One caveat. There remains plenty of uncertainty and during any given day or week, the market might look like like a jack rabbit in a dog park. But put on your blinders and focus on that one thing. Is the economy headed for better times or not?