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Why are investors pouring money back into the stock market, despite the grim economic status of the country? -- A member of Stock Card's private community
Questions similar to the above are flooding the investors' communities and online media. It seems that the stock market's movements, and investors are being quite irrational. While the answer to such questions is quite complex, there is a simple underlying logic that drives such seemingly irrational behavior. In this short blog post, we'd share the summary of the analysis we just completed at Stock Card HQ (the virtual HQ) to explain why investors are rushing back into the stock market, despite the grim state of the economy.
The seemingly irrational movement of the market
The three major stock market indices in the U.S. have lost between 25% to 30% of their value between February 18th and March 23rd. The decline wasn't surprising considering the effect of the COVID-19 on halting production and consumption globally. However, what the market has done after March 23rd is surprising to many people. Between March 23rd and April 16th, the same three indices have gained between 23% to 25% even though the economic activity hasn't resumed to the pre-COVID-19 levels. In the absence of economic recovery, it is puzzling to observers and commentators to see such a seemingly clear irrational behavior. Something has got to give.
What's going on here?
To solve the puzzle, let's discuss how people and algorithms make investment decisions. Making investment decisions is a probabilistic process by nature. You would invest more when there is a higher chance of a return, measured by the price you are paying for assets compared to their estimated value. If you pick up stocks at a better price compared to their fair valuations, you will win. Following such logic, investors and algorithms must believe that they can invest in the stock market at better prices now. Are they correct?
Let's look at the data! On the Stock Card platform and the Stock Card of each company, there is a specific section for the fair share price information. In this section, Stock Card automatically collects, aggregates, and visualizes the mathematical calculations that are commonly used to calculate the fair share price of a company. We use price to sales, price to earnings, price to free cash flow, and price to book value ratios, pull financial analysts' price target, use all that information to calculate companies' fair share prices, and compare them with the current prices. Those calculations show whether a stock is over or undervalued at its current market price.
Using the aggregated numbers for all available Stock Cards, we compared the distribution of undervalued and overvalued stocks between April 2020 and February 2020. The results are quite telling.
On Monday, April 13th, when we did the analysis, there were 6,743 companies on the Stock Card platform. Those are publicly traded companies listed on NYSE, NASDAQ, and OTC markets with a market cap of higher than $300 million. Among them, and as you can see in the above image, shares of only 2% of the listed companies were overvalued. When you compare that number with February of 2020, nearly 6% of the companies with a market cap of higher than $300 million, listed on NYSE, NASDAQ, and OTC markets, were overvalued. Simply, when investors and algorithms pour money back into the market, it is because they believe the odds of success are in their favor. Because of the price declines between Feb and March, the chances of throwing a random dart at the stock market board and hitting an overvalued stock is nearly three times (6% v.s. 2%) lower now compared to February of 2020.
Looking at the stock market movements with a lense of probabilistic decision-making is one of the best ways to understand why the stock market moves, albeit sometimes quite irrationally. In addition to the above analysis, the rush to invest back in the stock market is exacerbated by the fact that for almost 11 consecutive years, we were dealing with overpriced equities. During those 11 years, most investors were longing for the possibility of investing in anything at lower prices.
It's not surprising to see the rush back into the market when you peel the onion of the stock market to its primary governing logic. Assuming long-term success in the stock market is dependant on investing in well-managed companies at a fair price compared to their intrinsic value. Currently, the odds of success in the stock market is higher than what it was a few weeks ago. That's why money is being poured back into the market.