In theory, yes, but we're in uncharted territory. Everyone is struggling to predict how this this temporary shutdown will impact the economy. The market will fluctuate wildly until we can start estimating what the actual impact will be.
There is a large risk element as well. People are currently choosing to invest in safer instruments instead of stocks. Sitting on the sidelines.
> Even in the worst case where four or five percent of the population die and the economy is impacted by quarantines for a few years until we reached herd immunity, I don't see how this lowers future earnings by 30% and more.
We're in the middle of a mass panic and a societal lockdown. People aren't going to rush out and immediately put their spending back to 100% of the previous levels. It's going to take a long time to get back to normal.
Stock prices aren't linearly proportional to earnings. For many mature industries, margins are thin. Small changes in earnings can have massive effects on stock price during normal times. This isn't a normal time, so those small changes will be even amplified even further.
> Even in the worst case where four or five percent of the population die and the economy is impacted by quarantines for a few years until we reached herd immunity, I don't see how this lowers future earnings by 30% and more.
Though, that worst case scenario a 30% drop seems low to me. For some particularly hard-hit sectors, a lot of business would go to 0 in the scenario you described.
* For some pretty ambiguous definition of "several" that I can't pin down with precision
I don't really get the bubble theory. Stock prices were "artificially inflated" because the Fed was keeping interest rates low. That causes people to borrow money and use it to invest with, because the risk-adjusted return on the investments is higher than the interest they have to pay to borrow the money. Which creates more demand for stocks and drives up the prices.
But that demand continues as long as the interest rates are low. It's the same as housing -- low interest rates and easy money increased housing prices, which then came to a head when interest rates started to rise and suddenly that demand fell off, sale prices fell and people were underwater on their mortgages. That's what happens when interest rates rise, which is why the Fed has been keeping them low for more than a decade, but they just fell even more. The "pop" happens when interest rates go up too fast. Stocks are down right now because of the coronavirus, not because interest rates went up.
The trick is how to get out of the low interest rates without causing the market to decline, and there are two options. One is high economic growth, so that natural demand can replace the demand created by low interest rates, which you take if you can get it but hasn't been the case recently. The other is inflation -- the government creates a bunch of new money and gives it out, which creates a tendency for nominal prices to increase and offsets the decrease caused by raising interest rates.
We may be at the point where that second one is making a lot of sense, because "high economic growth" seems pretty unlikely in the immediate future, but "print a bunch of money and give it to people" is exactly the sort of thing you want to do during hard times when there are existing deflationary forces in effect. And then it sets you up for a subsequent recovery that allows interest rates to rise as the deflationary forces wane and the inflationary effect from creating the new money catches up and allows you to raise interest rates without reducing nominal asset prices.
Let's not forget the impact of big stock buybacks, which served to reduce the float of shares and make per share earnings go up. This is small-time financial card shuffling, but for a few years investors believed that all kinds of companies with only modest sales growth were incredible profit-making machines because their per-share earnings were surging. So these companies got very high valuations.
Now if we're heading into hard times and there's no available cash to do the buybacks, the game stops. And with that -- the illusion of fast growth companies goes away
This is the theory in a finance textbook. I worked as a hedge fund manager for several years, and there are plenty of people who do not try to project the earnings of companies in order to value them. It's not that easy to do with any certainty.
What you get is more ordinary concerns driving investment:
- Customers have allocated some money with my firm. I need to buy something. (Or the reverse!)
- I don't know what to buy, I'll just buy the index
- This has gone up for a while, better get on the bandwagon
And a whole lot more.
Answer: yes they do, ergo stock prices are affected by much more than just estimates of futures cash flows.
[1] https://www.aeaweb.org/articles?id=10.1257/aer.101.1.1
[2] https://www.nobelprize.org/prizes/economic-sciences/2013/shi...
A lot of companies were already over leveraged so this is probably not a good situation to be in with so many things that could mess them up.
The difference between theory and practice is bigger in practice.
Meaning it's supposed to include it in theory, but in practice it's only an incomplete description. Humans are irrational and information in a market is never perfect.
For instance, assume that investors don't really care about cash flows beyond 10 years. After all our government puts out 10 year budgets. It seems a reasonable assumption.
So in that case, if you run the numbers you will find that the discount rate has to be about 20% annually in order for the 10th year earnings to be worth 10% what they are today:
80%^10 = 10.73%
At that rate, the first 3 years of earnings represent 54% of the value, and the first 2 years are 40% of the value.
All of this ignores the book value of a company, but often these days companies are funded by debt, so equity investors may not even be expecting to pick up the scraps of a bankrupted company.
Finally, stocks themselves may have been at an unfortunate peak, right at the time of this correction. So they also have to correct whatever amount they were overvalued by in the first place.
Sentiment is what takes this all down.
In theory. But there are hedge fund managers who go on CNBC everyday with "models" based on pure speculation that they can't even justify with a loose DCF model.
The stock market is probably 1/3 investors in the true sense, 1/3 algorithm and momentum traders, and 1/3 unbridled YOLO speculation.
Keep in mind that these future earnings for a given company might also be "zero forever", if the company goes bankrupt. That is, for each company, there are two main scenarios: the company recovers together with the rest of the economy, or the company goes under. If the probability of the later scenario increases, the stock price should decrease to match.
And there's also the second-order effect that this probability of going "zero forever" becomes harder to calculate in these times of high uncertainty, which makes holding stock of the company riskier, so those with less tolerance for risk sell the stock.
The labor force not working is what's going to cause the decline in GDP, not retired people dying.
I'm not saying it's not bad, it's obviously horrific, but I think the deaths themselves will not overly impact the economy.