Valuation of the stock market against the economic situation
The volatility on the stock markets produces some alarm among investors who are speculating about the causes of the falls. Many clients have called us and expressed typical concerns regarding these events. Hence, in the Markets Department at BBVA in Switzerland we feel it would be interesting to explain what factors affect stock market prices.
Due to the economic situation that we are confronting these days, it seems relevant to discuss issues of utmost importance to investors and that, for some reason, continue to cause confusion and puzzlement, even among professional investors and analysts.
The topic we will discuss this month is about stock market performance and the valuation of companies against the economic situation.
Over the last few months, we have seen a very strong decline in world economic activity, with falls in GDP (Gross Domestic Product) not seen since the great depression of the 1930s.
Despite this very negative economic performance, the equity markets have rebounded strongly since the March lows, producing a significant disparity between stock index performance and economic activity.
For some reason, the vast majority of investors think that stock market developments are an exact reflection of growth or economic activity. In fact, that is not necessarily the case:
- First, the stock market discounts the business and economic future for six months in advance. This factor is critical since rather than the current situation, what matters are the divergences between what happens in the next six months and what the financial markets discount at this time.
- Second, the valuation of companies depends on factors other than economic activity, such as business margins (currently at all-time highs) and interest rate levels, which make a certainly expected yield more or less attractive compared to what can be obtained by investing in a bank deposit or in a government bond.
The 70s, one of the moments of greatest growth
Proof of this is the 70s when the stock market went 10 years without rising but the economy experienced one of the fastest-growing moments in its history. Or, another closer example, the last decade, a period characterised by weak economic growth but with one of the most bullish stock markets in history.
Following from the above, and as we have explained in many forums and presentations, the current moment is very specific because investors are faced with expensive stock markets in historical terms and very weak expected structural growth.
This situation, already experienced in the past, should imply very low long-term structural yield along with high volatility in the financial markets.
In our opinion, the current situation is an invitation to buy products with an equity approach and the purchase of wealth-focused products, specially designed for environments such as this one. These products have the particularity of converting and transforming market volatility into positive yield for investors.
Do not hesitate to consult your investment advisor for any questions regarding this article.
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