How to correctly interpret this “stock market crash”

When you buy stock, you become a part-owner of the company, but in practical terms you’re buying a share of the company’s future earnings.

The market prices of shares continually fluctuate, and at any given time, they’re worth whatever investors are willing to pay for them. This isn’t always directly related to the economy or the company’s earnings or earning expectations, but over the long run earnings have a lot to do with how investors value shares. When the economy goes south, and earnings with it, share prices tend to decline.

News media sensationalize, because it gets them a bigger audience, which translates into more ad dollars. From reading or listening to the news coverage, you can get the impression the world is ending. (For example, a CNBC headline said, “This was the fastest 30% decline ever, exceeding the pace of decline during the Great Depression.” Duh, they didn’t have computerized trading then!)

Over the last several weeks, as the coronavirus pandemic has spread across the world, the stock market’s decline has been swift and deep. The news media have used terms like “panic” to describe the selling. However, the selling for the most part has been orderly, and the lower stock prices are a rational response to investors’ changed expectations about will happen to the economy and company earnings as a result of the coronavirus (which I’ll call “C-19” for short).

The stock market is forward-looking, and prices in events it expects to occur within 6 to 12 months. Thus, the stock prices we see now reflect what investors think is coming, not just what has happened so far.

The best-known stock market index is the Dow Jones Industrial Average (DJIA or “Dow”), but the S&P 500 is considered a better measure of the market because it’s based on roughly 500 stocks, whereas the Dow is based on only 30 stocks. Thus, the S&P 500 is more representative of the market as a whole.

On November 8, 2016, Election Day, the last day of trading before America learned its next president would be Donald Trump, the S&P 500 closed at 2,139.56. On January 20, 2017, a Friday and Inauguration Day, it closed at 2,271.31. On Friday, March 20, 2020, it closed at 2,304.92. Therefore, after the C-19 selloff as of Friday, the stock market as measured by the S&P 500 index is up +7.1% since Trump was elected and up +1.5% since he took office.

During the 3 years and 2 months since he took office, the economy has grown at an average yearly rate of 2% or so. The S&P 500 topped on Feb. 19, 2020, at 3,386.15, which was a rise of 49.08% over that time, which is about 15.9% a year. During that time, earnings grew faster than the economy’s output, but not that much faster. Nowhere near it.

What happened is investors paid more for a given amount of earnings. They did this partly because falling interest rates reduced the returns of competing investments. Another important reason they did is because the economy, although it wasn’t growing fast, seemed to be running smoothly, there was a feeling of prosperity, and investors had grown optimistic about future prospects.

Three other factors also played a role in stocks’ dramatic rise of recent years: (1) Companies going private and stock buybacks have reduced the number of shares available for trading, driving up their prices by reason of scarcity; (2) the buybacks have supported stock prices; and (3) many investors believed the Federal Reserve would step in with interest rate cuts if the stock market fell too much.

Then C-19 happened and upset investors’ calculations. Many stock market observers had already thought the market was overvalued and a “correction” was overdue. The fact the economy was showing signs of slowing was another factor. In 2019, investors also worried about a recession in 2020, but until C-19 those concerns had faded. C-19 has now made a recession a certainty.

C-19 is forcing the government to shut down broad swaths of our society and the economy to try to contain its spread. Inevitably, this will hurt businesses’ sales and profits for an unknown amount of time. The correction has deepened has the C-19 crisis has evolved into a major disruption of the economy. The market’s continued slide is a rational reaction to these changing expectations.

Many experts believe the economy and stocks will recover quickly after the C-19 crisis is over. How much lower stocks go probably depends on how effectively the virus is contained and what is done to help the economy recover. For many businesses, the setbacks may be temporary, and this enters into investors’ calculations. For the most part, these experts still expect a “short but sharp” or what some call a “V-shaped” decline and recovery, both in the economy and the stock market. [Update: Stocks recovered over 20% in 3 days, March 23-26, but experts say they might retest the market lows again in the days ahead, and that will be a time to buy stocks if they do.]

The major banks variously expect a 12% to 24% decline in 2nd quarter economic output, and some analysts think the stock market will fully recover in 2nd half of this year. Of course, they could be wrong, and it could be worse or more prolonged than that. Some epidemiologists worry that C-19 could sweep through America in three waves stretching over 18 months. They apparently assume a vaccine will be available after that.

Market historians say that of the last 11 major epidemics that impacted stock markets here and abroad, in all 11 cases, the markets fully recovered within a year. Of course, this pandemic is bigger and more destructive of economies than any of those previous epidemics, so we’re in uncharted territory and the damage could be deeper and longer lasting this time.

The current advice of investing experts is that if you own stocks, whether in the form of stock funds or company shares, in an IRA, 401(k), Roth, or taxable investment account, you should do nothing, don’t sell, ride it out. I agree with that 100%. That was my experience in the 2008-2010 market crash.

Again, to put things in perspective, this is just another stock market correction. They’ve happened before, and will happen again. This one albeit is a bigger than average one, but it’s by no means the biggest ever. It’s probably not over yet, and the stock market likely still has farther down to go, because C-19 infections are still increasing and with the U.S. effectively now going on lockdown, the economic impacts are bound to get bigger and the worst are just starting to take effect. There will be mass unemployment, at least for a few weeks, and possibly for months. But it’s not a freefall, either in terms of our society, the economy, or the financial markets. It’s a controlled slide. There’s a bottom to this, and the economy and stocks will recover, we just don’t know when or how long it will take.

The bottom line is, I’m not frightened of this stock market “crash,” and you shouldn’t be either. This isn’t a replay of what happened in 1929. After all that has happened so far, stocks are still higher than they were in November 2016, and much higher than they were in 2008 or 2009, and there’s lots of reasons to think they’ll bounce back quickly.

But if C-19 is the end of the world, you won’t need investments or money anyway, and what happens to your savings can’t stress you out if you’re dead. Hey, I’m just looking at the bright side; as they say, every cloud has a silver lining.

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