Could the Stock Market Be Rational?

By David Montgomery

John Briggs observes early in this article that “the stock market seems to have shrugged off economic reality.” He puts his finger on the persistent problem of understanding what drives the stock market. Small blips on the economic horizon produce disproportionate reactions and corrections, as we saw when worries about trade wars dropped the market at the end of 2018. In this case, however, it strikes me that the market is evidencing almost unique far-sightedness and rationality in assessing the relative size of the real economic impacts of the China Virus, with a good bit of pessimism about the harm that political responses might do.

Interpreting the stock market reaction to the China Virus is admittedly a game without rules, because there is no way to test alternative explanations without waiting for the benefit of hindsight. My favorite, and possibly unique, explanation is that investors are showing a remarkable flash of rationality. Aside from the effects of pumping up unemployment payments on willingness to return to work, it seems to me that neither the shutdown nor the virus itself have much of an effect on productive capacity or potential GDP. Plant and equipment investment may have slowed, but nothing is destroyed. Goods remain in the inventories of stores forced to close, no buildings were damaged, and workers will not lose their skills over a 6-month layoff. Therefore, we should return to baseline GDP levels and growth rates, with a bite taken out for the period of shutdown and subsequent rents generated by bankruptcy proceedings. Say’s Law can be expected to work and as business resumes and unemployment falls, restored profits and labor income will bring consumption back. Bankruptcy does not destroy productive capacity, though it does transfer rents from productive investors to lawyers, consultants and investment bankers. Only the net loss of output and earnings during the shutdown and recovery will matter and that can be calculated.

For simplicity, suppose investors expect a 20% drop in output for 6 months, or for a metric more closely related to earnings, that S&P500 earnings are 20% lower than predicted for Q2 and Q3. The latter is consistent with analysts’ forecasts at the end of Q1, as reported here.

Still simplifying, suppose valuations are based on a 5-year payback. The forecasted loss is then 2% of 5-year output and/or earnings. The S&P500 was down on April 24 by 12.5% from December 2019, or 5 times the predicted loss in earnings when computed over a 5-year period.

The greater drop in stock prices could be due to transaction costs of bankruptcies and restructuring, greater pessimism about the depth and duration of the shutdown, or, most likely, perverse effects of current and future bailouts and government meddling.  Based on that, I see nothing irrational about current market valuations. Losses taken by current owners suffering from a fire sale or bankruptcy will become, aside from rents taken by lawyers, consultants and investment bankers, windfalls to the investors who buy up distressed assets.

What puzzles me is how a market that is so often characterized by irrational exuberance and panic could in this case be so rational and farsighted. And, more puzzling still, pretty sanguine that political responses will not make matters much worse. Vernon Smith provides a much more eloquent explanation of this phenomenon in the Wall Street Journal.

As a final word, I must mention that this article does not give investment advice, and anyone who believes it does so at his or her own risk.