30 January 2021

On Bubbles – Part I

Are financial markets in a bubble?

The global economy was running along when out of nowhere a pandemic pushed global markets into unprecedented crisis. Does the following stock market index reflect the impact of the COVID pandemic?

Put in the context of the past decade of market returns, the crash associated with the pandemic is just a blip: Less than a year later the stock market has recovered and resumed its upward trend at an annualized rate of 12% per year.

Stock markets are fundamentally forward-looking: Investors pay for future returns on stocks.  Unexpected losses attributable to one-time events that don't disrupt the long-term profitability of a company shouldn't alter a stock's value or long-term price.  Is the pandemic just a blip in the economic value that these companies can generate?

Is it possible for the world to just take a long vacation and then get back to work like nothing happened?  Before and beginning the pandemic plenty of people thought not.  People who have lost jobs and businesses sure feel like the pandemic turned their financial world upside down.  But governments stepped in with massive financial interventions – e.g., the U.S. CARES Act – and those sorts of one-time loans arguably could smooth over a one-time virtual economic holiday.

Stock markets aren't the same as the economy.  (But they're related.)  Yes, economies overall took major blows.  Some industrial sectors were devastated and probably won't recover.  But others grew enormously.  The pandemic could have catalyzed and accelerated "creative destruction" that was already underway – e.g., telework and virtual retail.  Companies in the decimated sectors are now underrepresented in the market, while those that serve the new economy have had their valuations appropriately boosted.

To be continued...

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