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I follow the market every day. It is rushing to recover losses over the last few weeks. However, stock prices are not mirroring the actual activity of the companies, only because liquidity in market shares costs more. There is no connection to company activity.

How does this make any sense?

  • I thought this had been answered before but I can't find a duplicate. If anyone finds one please mark it and I'll delete my answer – D Stanley Mar 26 at 18:29
  • Welcome to Stack Exchange! Do you have a question? – Tanner Swett Mar 26 at 18:30
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    They're bidding up stock prices..It's the madness of the crowd. Or maybe you can drown your sorrow in stimulus money? It's hard to see how that will be sustainable given the likelihood of much higher unemployment and lower corporate earnings which will start coming in when earnings season starts in early April. That will give some insight into the economic havoc and that will only include 1 month of economic contraction. Imagine what it could look like in July after 3 months of this, if it goes that far. – Bob Baerker Mar 26 at 18:33
  • @BobBaerker See my answer. A 20% drop will be worth only 1.1% in the long term. – juhist Mar 26 at 18:33
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    The market is forward looking. In addition, when fear drives the market, analytical formulas are not applicable. – Bob Baerker Mar 26 at 18:37
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Stock prices are not tied to current performance, they are tied to future performance that may be tied to current (and future) market conditions. So if the market thinks that a company will perform poorly going forward based on the current environment, then it's likely that it's stock price will suffer.

The financial (i.e. ignoring voting rights) value of a stock is tied to the future cash flows of that portion of ownership. That cash flow can come in the form of:

  • Dividends
  • Acquisition/Merger
  • Liquidation
  • Buybacks

Income for a company increases its value in an acquisition/liquidation scenario - and dividends/buybacks are a way to directly distribute profits to shareholders. So the more profitable a company is in the future, the more it's stock is worth. That's why you see many companies like Facebook lose money hand over fist for years, but their stock is highly valuable - because the expectation is that at some point the company will become profitable as it builds market share, loyalty, etc.

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    I would instead say that prices are tied to the EXPECTATION of future perfomance. So if there happens to be for instance a major pandemic, that creates the expectation that performance will be much worse in the near future. Which drives prices down, which creates the expectation that long term performance will be better, causing longer-term investors to buy at what they expect are bargain prices... (And for many investors, the return from dividends &c is secondary to the expectation of someday being able to sell the stock for more than they paid.) – jamesqf Mar 31 at 18:10
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Consider an individual company. Or, a portfolio of companies.

At discount rate of 10%, and growth rate of 4%, one dollar of yearly income is worth 18.3 USD. (If you want the formula, open GNU Octave or Matlab and type sum(1.04.^[0:1000] ./ 1.10.^[0:1000]) into it).

Now, if this year, income drops by 20%, instead of getting 1 USD, you get 0.8 USD, the company (or portfolio of companies) is worth 18.1 USD.

According to this calculation, a temporary 20% drop to gross domestic product should cause an approximately 1% drop in stock prices (18.1 / 18.3 = 0.989 so more precisely it's 1.1% drop).

Yet, stocks have fallen over 25%.

That doesn't make sense to me.

For some reasons, investors have panicked. They should not have panicked.

Now the recent rise in stock prices from the bottom just is due to slightly lessened panic.

That still doesn't change the situation that stocks are 25% cheaper than they used to be.

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    Imagine if "shelter in place" lasts 4 months. You don't think that 4 months of lost revenue for many companies will have a significant impact on their future cash flows? Especially as they have debts and fixed expenses to take care of in the meantime? – D Stanley Mar 26 at 18:34
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    But GDP is tied to profit, not revenue (among other things). So if revenue falls by 20%, then profits will drop by significantly more (and may disappear for many companies as they go bankrupt). I'm not saying that the 25% drop is completely justified, but I think there's a chance it could actually be worse for equities. – D Stanley Mar 26 at 18:59
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    @juhist It might be a bit of a stretch in this case to imply that only bad companies will go bankrupt due to the crisis. There certainly could be some good companies that, due to no fault of their own are forced into bankruptcy. To put it another way, sometimes it is possible to make no mistakes but still lose. – Michael Mar 31 at 19:45
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    Please correct me if I'm wrong: in 3020, you'll get $107978999416658768 yearly income from your investment, but since a dollar in 3020 is only worth $0.00000000000000000000000000000000000000000405 in 2020, this future yearly income is only worth $0.000000000000000000000000437 in current dollars. Now that makes sense to me. – Eric Duminil Apr 5 at 8:21
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    @Michael I would suggest that if a profitable company doesn't have an emergency fund, it's irresponsible behaviour. Ditto for individuals. However, companies in highly-competitive markets might not be able to make enough profit to build up one. That is the free market signaling the company that it thinks there are too many companies in that market. Apparently it won't just get rid of some, though - it will get rid of none, then get rid of them all at once when there's a pandemic. – user253751 Apr 5 at 23:40

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