The key role of Expectations and Anticipations in Stock Pricing in a turbulent period
The last week was very euphoric for the western markets which hit historic records, like the CAC 40 which exceeded its record of the 2000s (just before the burst of the dot.com bubble). However, a main question arise: what are the drivers of stocks markets in this uncertain time?
First of all, a bullish market is driven because there are more “good news” than “bads”. This may seem trivial but it therefore implies that the various information are incorporated in the price of listed assets from the real sphere (economic, financial, geopolitical or others).
On this point, it is necessary to define the dominant paradigm of the efficiency of the markets of Eugene FAMA which defines various degrees of effectiveness of the markets to process the news.
Under this principle, the valuation of an asset goes through an evaluation of the agents of the positive or negative content of a news. This dominant theory assumes the rationality of economic agents and those even in the financial sphere. A news will be qualified as good or bad by all the agents, whatever their profile. And this point is subjected to debate …
Are we rational in Stocks pricing mechanism?
Under this principle, the current economic and financial situation (in the West, USA and Europe) is therefore assumed as « Good » by a majority of investors or the future is considered to be on a « Good momentum » despite the events related to the pandemics (faraway).
- The effect of Central Banks policy
Central banks (CBs) play a crucial role in market sentiment because they directly rule the famous « interest rates » which directly conditions the money supply. Access to fresh and ‘free’ cash guarantees a low borrowing cost necessary to support investment.
The stance of central bank policies is therefore decisive: Lower rates will imply a massive cash injection profitable to stocks while an increase will lead to cash restriction and therefore to restrict loans. In this case, stocks prices mechanically decrease as bonds prices increase.
The current position of the CBs in terms of low interest rates is therefore very profitable to stock prices ! Interest rates are near to the zero lower bands but empirically negative since the last crisis. Cash injection are then scheduled to support economic recovery. However, Inflation data released recently indicates possible negative effects for the present and future sustainability of such plan.
Therefore ,massive communications of the CBs on inflationaims to reassure the market on its lax monetary policy … No brutal changes is schedule by CBs as Inflation is EXPECTED to be transitory and not permanent. Then, the expectations of possible rates increase are incorporated but at short term no drastic changes are expected so stocks prices are still push forward mechanically.
- Shortages … negative or positives news ?
Intuitively it would be wise to consider the current shortages as negative, affecting the purchasing power of households (therefore consumption) through inflation, forcing output to decrease due to a lack of means / factors of production.
But the shortages also push the prices of commodities upwards which is ultimately good news on financial aspects.
Oil, gas and mining companies (producers of raw materials) are doing very well, price increases because they cannot keep up with the growing demand! The shares of these firms are therefore pushed upwards by the expectation of good operating results.
And this mechanism has repercussions on all the related sectors. Banks and Financial Institutions also benefit from price increases through their activities of financialization of these goods, asset management etc … investors are thus encouraged to take advantage of investment products on commodities to hedge or diversify their portfolios. In the end, the shortages are good news from a financial point of view because as long as they last the returns will only be stronger!! (Mixing with the policy of CBs which favors short sales and we get a winning combo!)
Expectations and Anticipations are then key factors in Stocks Pricing as Confidence in the Future is a crucial pilar of the system. If all expectations are based on a non-permanent shortages and non-permanent inflation … the market sentiments are globally optimistic and then stocks prices increase!
- Do Expectations are rational ?
The economics consequences of the COVID crisis are not fully determined because the mechanic ‘’rebound effect’’ due to Central Banks interventions undercover them. In the case, the consequences of CBs laxist policy, the duration of shortages and Inflation are also not yet fully clear and observable …
As the CBs policy is based on inflation target and support to economy, they are facing a perpetual dilemma between expansive monetary injection (to increase Inflation to support economy) and restrictive policy to cuts Inflation and calm the economic overheating …
The same issue appears in uncertain time when financial market reach summits … does it is the sign of an overheating? Or are we fall into a short run excess of optimism and monetary illusion?
The last decade is marked by low-interest rate and unconventional policy and so we fail to address the questions as we fail to properly gauge unconventional policy effects … maybe we will see in a near future …