Breakingviews: U.S. stocks send a mostly mathematical message

A strong stock market does not equal a strong economy. There’s a different explanation for the record level the S&P 500 Index hit during Wednesday’s trading day. The recovery in share prices – including Apple becoming the first U.S. public company to hit a $2 trillion valuation – may reflect little more than the Federal Reserve’s squashing of interest rates.

In simplified theory, a company’s worth should be the value today of a never-ending stream of cash flows to investors. Over the long term, that’s roughly equivalent to future earnings. They’re usually valued using a discount rate, which knocks down profit in future years to account for delay and uncertainty.

A couple of bad years, therefore, aren’t a huge deal for company valuations even if they are horrible for people in the real world. A significant change in the discount rate, which affects today’s value of earnings in every year to come, matters.

That’s where the Fed comes in. Because of Covid-19, the U.S. central bank has committed to buy government, corporate and other debt to keep markets working smoothly. That has knocked the yield on 10-year U.S. government bonds, often used to derive discount rates, down to roughly 0.5% from some 2% previously.

The formula for present value is this year’s earnings divided by the discount rate less the earnings growth rate. Take a fictional company making $100 million a year, a discount rate of 10% and expected earnings growth of 5%, and its present value is $2 billion. Run those numbers again with a discount rate that’s 1.5 percentage points lower, and its value goes up to more than $2.8 billion. That’s enough to account for most of the 50% gain in the S&P 500 since its late March low.

Furthermore, even if earnings fall by 30% forever, the lower discount rate means the hypothetical company’s value would still be $2 billion, right where it started. That’s another way to think about how the stock market has regained its February pre-pandemic high.

That’s oversimplified, of course. Sentiment drives prices too. Covid-19 could lead to permanent changes in behavior, while unemployment at over 10%, still more than double its level before the pandemic, could cause long-term damage. For now, though, stocks may not be sending an economic message – just a mathematical one.

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