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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.

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