New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Why is the Market Doing Well Lately?

A reader writes in, asking:

“We’ve basically had a full blown bull market since the bottom in March. VTI has a positive 34% return in just two months. How does that make any sense at all? Unemployment is higher than any time since the Great Depression. The death toll continues to climb, and everybody still says that a vaccine is a year away at least. What gives? It seems like the market has become completely disconnected from reality.”

The first thing to understand is that there’s a big difference between “the stock market” and “the economy.” And this distinction is not a new COVID-19-related phenomenon.

The value of the stock market at any given time is essentially the market’s consensus as to the present value of the expected future earnings of publicly traded companies. That is, the stock market is concerned with the profitability of publicly traded companies. Nothing more or less than that.

So unemployment only affects the stock market to the extent that it affects expectations of profitability. If unemployment goes up by, for example, 10%, that doesn’t mean profits will go down by 10%. The change in expected profits could be greater or smaller than the change in unemployment. Relevant factors there would include:

The second critical point to understand is that that the stock market’s valuation is based on an “expected” (i.e., probability-weighted) value of earnings.

The easiest way to understand this concept is to imagine a company that is undergoing a massive lawsuit. If the suit fails in court, the company would be worth $100 billion. But if the suit succeeds, the company will be bankrupt. Given those facts, what is the company worth right now? That depends on the likelihood of the suit succeeding. If the suit has a 30% probability of success, the company should be worth $70 billion right now (that is, 70% chance that it ends up being worth $100 billion, 30% chance it’s worth zero). If the suit has a 50% probability of success, then the company should be worth $50 billion right now.

As the apparent probability of success of the lawsuit changes, the firm’s value will change.

In the middle of March, extremely catastrophic COVID-19 scenarios (e.g., millions of deaths in the U.S.) were being discussed as real possibilities. We really didn’t know what to expect, and the range of potential outcomes was very wide.

Now, those very worst-case scenarios appear quite a bit less likely. Even if the most likely outcome is approximately the same as it was two months ago (i.e., still not good at all), the probability-weighted outcome can be quite a bit better, because the very worst outcomes have become (apparently) less likely.

But of course that means that the market could still fall again in the near future. If something happens to make the really bad outcomes appear more likely — or if something happens that makes the most likely outcome appear somewhat worse — or if something happens to make the best-case scenario outcomes no longer as good — then the market would probably fall again.

New to Investing? See My Related Book:

Book6FrontCoverTiltedBlue

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2020 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security