Q&A: Why is the stock market so high?

April 26, 2021   |   Investing

Today, we’re sitting down with LifeGuide Partner and Chief Investment Officer, Zak Lutz, to answer some of the most frequently asked questions we receive. This is the fifth part in our six-part Q&A series.

Q: Why is the stock market so high?

A: To begin unpacking this question, it’s helpful to acknowledge the fear often living behind this question. When the market is low, it can feel scary and unsettling as we watch the numbers in our accounts go down. Yet, when the market is relatively high, it can also feel scary and unnerving as we question whether the growth is sustainable or wonder how high it can really go.

These fears are certainly understandable, though not necessarily well founded. It can be helpful to realize what drives the market and that it is more rational than it can seem.

The market is largely driven by the expectation of what future company earnings will be and how valuable those earnings are in today’s dollars.

In other words:

If the growth of earnings is expected to go up in the future, the stock market will go up today. (Assuming inflation expectations don’t change.)

The stock market is predictive, not perfect.The stock market isn’t concerned with what’s happening now, it’s making a prediction on what things will look like in six months, a year, or even two years from now. The reason it can seem irrational is that it doesn’t always get it right.

One way to think about the stock market’s predictive nature is this:

Say you want to buy a house. You also recently learned that a new factory is going to be built in your town next year. This new factory will bring a large influx of new people to town, all of whom will need a place to live. Naturally, you would predict that, as the demand for housing increases next year, housing prices will go up. Yet everyone else who may be in the market to buy a house has also heard this same news. They may draw the same conclusions as you and also believe it’s smarter to buy a house sooner rather than later. In this scenario, it’s likely that house prices increase in the near term, even though factory construction won’t begin until next year. You would be okay paying a higher price now because you anticipate even more demand—and higher home prices—next year.

Now, that factory may or may not actually be built in the anticipated timeframe or impact the town’s housing prices as you planned. It’s possible that the assumptions and economics of your purchase may not work out as you predicted they would in the near term.

The stock market is similarly predictive. And it is currently predicting higher company earnings causing prices to rise today. 

Here are some of the factors we’re seeing behind the expectation of higher earnings:

1. We’re finally beginning to see a light at the end of the tunnel in regard to the COVID-19 pandemic. More vaccines are being rolled out every day and the effectiveness of these vaccines appears promising.
2. The market is predicting increased spending as normalcy returns and people are able to go out to eat, attend public events, etc. There is a lot of pent-up consumer demand. For example, the pre-pandemic savings rate was around 7% and has nearly doubled to about 13%. Capital Group has even penned the 2020’s as the next “Roaring 20’s” in reference to the large economic growth of the 1920’s after the Spanish Flu pandemic came to end in April 1920.
3. Massive, global stimulus has done its job in holding things together during the pandemic and will continue working its way into the economy. The stimulus packages from Congress have helped and the Federal Reserve has done a tremendous amount with various monetary tools, such as low interest rates.
4. Companies have used this crisis to accelerate innovation and are already seeing very strong earnings, even with slowed sales. We will likely see the fruits of these innovations for years to come.

Bottom line: The stock market is predictive, not perfect. There are many factors behind projected increased earnings for 2021; factors which may or may not play out as predicted.