1/ Is the stock market response to COVID-19 a once-in-a-generation mispricing? Has the pandemic really reduced the fundamental value of the US stock market on the order of 30%?
#coronavirus #covid19 #investing #stockmarket #behavioralfinance #socialecon #socialfinance
#coronavirus #covid19 #investing #stockmarket #behavioralfinance #socialecon #socialfinance
2/ I don’t know the answer, but there’s reason for suspicion. Suppose that rapidly-increasing social distancing policies and behaviors continue, along with increased testing and research on treatments.
3/ Some hard-hit countries are already getting the upper hand on their epidemics, which raises the hope that the US will also gain enough control in the coming months to start to limit the tragic consequences.
4/ But economically costly social distancing measures will likely be needed for an extended period of time.
5/ So consider an adverse-case scenario in which corporate profitability is reduced by 50% for two years before bouncing back. The stock market should impound discounted profitability over the next hundred years.
6/ Two years of reduced profitability would be only a small piece of discounted fundamental value. So based on a superficial first glance, the immensity of the stock market drop is hard to understand.
7/ Counterarguments and discussion.
In general the stock market is leveraged relative to fundamentals of the overall economy. This can help explain a large reaction—but we are talking about a *very* large reaction.
In general the stock market is leveraged relative to fundamentals of the overall economy. This can help explain a large reaction—but we are talking about a *very* large reaction.
8/ Maybe the market was in a huge positive bubble before the pandemic, so much of the drop is just a correction. COVID-19 may in part be a catalyst for the correction.
9/ But if so, once US COVID-19 deaths start to decrease, will market optimism resume?
10/ Maybe the bad news for fundamentals does not come “directly” from the pandemic in the form of illness and social distancing measures. Maybe the main damage to fundamentals cost comes from other regulatory responses to the pandemic.
11/ For example, has the pandemic increased the probability of increases in the corporate tax rate, capital gain taxes, and security transactions taxes? All would hit the stock market.
Or of socialized medicine, which would hit the biotech industry in particular?
Or of socialized medicine, which would hit the biotech industry in particular?
12/ Also, in addition to its massive short-term effects, will the pandemic have a long-run adverse effect on certain industries (airlines, hotels, restaurants)?
13/ Even if so, this is not necessarily a shift of fundamental value out of the corporate sector. To a large extent it may shift value to other existing firms.
The rising stock market in recent years comes mainly from large growth firms. (E.g., tech giants.)
The rising stock market in recent years comes mainly from large growth firms. (E.g., tech giants.)
14/ Such firms have achieved high profitability via attractive ecosystems with massive scale economies. A shift in demand from lower profit sectors to tech and entertainment giants might increase overall profits, building investor optimism.
15/ On this note, Amazon today announced that it is increasing pay and hiring 100,000 warehouse and delivery workers to meet rising demand.
wsj.com/articles/amazo…
wsj.com/articles/amazo…
16/ On the other hand, some consumer shifts would likely reduce overall profits in the corporate sector. An example would be a shift toward household production of food (cooking at home) instead of buying from restaurants.
17/ Also, pessimism may result in a recession and a decline in business activity. This may be exacerbated by feedback from the stock market to fundamentals. Such recessions have real costs. But recessions are temporary.
18. So again, would this justify such a massive decline in stock market value?
19/ I’m raising questions, not giving answers, and I’m certainly not offering investment advice. But the sheer magnitude of the price drop is remarkable. At least relative to this (superficial) look at news about fundamentals.
20/ A postscript to this thread:
This market panic story also suggests that Treasury bonds may be overpriced, based on “flight to safety.”
Also, I gave somewhat short shrift to the possible psychological underpinning of panic.
This market panic story also suggests that Treasury bonds may be overpriced, based on “flight to safety.”
Also, I gave somewhat short shrift to the possible psychological underpinning of panic.
21/ I did suggest salience effects: that news about deaths are attention-grabbing, and that school and commerce closures and shortages affect daily life, making them highly salient.
22/ The idea that COVID-19 has devastating consequences for market fundamentals has a large “idea habitat” (Berger and Heath 2005), i.e., a greater prevalence of environmental triggers.
onlinelibrary.wiley.com/doi/abs/10.120…
onlinelibrary.wiley.com/doi/abs/10.120…
23/ Contrast this with a hypothetical disaster that interferes, e.g., with energy infrastructure without endangering human life nor interfering much with daily life.
24/ People also tend to misunderstand exponential growth. At first glance this suggests *under-* rather than *overestimation* of the consequences of COVID-19. This very likely occurred at first.
25/ However, such confusion also suggests that adverse updates (rapidly rising death rates; announcements of social distancing measures) that were in principle predictable based on recent information may have come as a surprise to many, and that feeling of shock feeds into panic.
