2020 has been a hard year for investors. News about the economy has been bleak, with headlines telling the story of high unemployment, falling GDP, and the onset of the first recession since the 2008 financial crisis. The stock market tumble earlier this year was swift and painful for many investors, but the recovery has been equally fast and surprising—by mid-August, the S&P 500 index had fully recovered and was once again reaching record highs. The same can be said of global stock markets. In the face of such troubling news, many people are left wondering, has the stock market lost touch with reality?
The key to understanding this seeming discrepancy is to remember two important truths about the stock market. First, stock prices reflect the expectation of future company profits, aggregated by millions of global market participants. Taken together, these millions of investors tend to produce reasonable prices. Second, markets are forward-looking; current prices reveal investors’ expectations about the future, not what is happening right now. The price of any stock is determined by investors’ calculations of the present value of all the company’s future cash flows. In other words, prices reflect a company’s income and performance, not just in 2020, but for years into the future.
The forward-looking nature of the market is interrelated with one of the fundamentals of investing – faith in the future. As Nate here at PFG has said, “This principle — optimism, or faith in the future — is the first great principle necessary to achieve actual investment success. The whole idea of investing is that your capital will be used in the creation of something better.” Even in the face of bleak news, most of us can summon the faith in the future to put our capital to work. If you’re not so sure, think about it this way: do you think the iPhone in 2030 be better or worse than the current iPhone? Will the 2030 Ford F-150 be better, the same, or worse than the 2020 model?
In the long run, innovation and productivity are the drivers of investment returns. While the news in 2020 is filled with uncertainty and fear, investors believe that business productivity and innovation will continue in the face of turmoil, and this expectation is reflected in current prices. While the ride may yet be bumpy, a resilient faith in the future makes it easier to hold on along the way!
For another perspective on this same question, we recommend this article, written by Weston Wellington, Vice President of Dimensional Fund Advisors: https://www.dimensional.com/us-en/insights/is-the-stock-market-divorced-from-reality