You Decide: How does the future impact the stock market?

Published 10:51 am Saturday, March 14, 2020

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By Dr. Mike Walden

The world has been shocked by the coronavirus outbreak. One part of the economy clearly impacted has been the stock market. The stock market is now in – what experts term – a “bear market,” meaning losses from the last high now exceed 20 percent. However, some predict that once the virus is controlled, the market could rebound just as quickly.

The stock market’s reaction to the coronavirus presents an opportunity to address how and why the stock market changes. I don’t mean offering tips on buying and selling stocks to make money. Instead, my goal in this column is to explain what influences the stock market, thereby allowing you to understand – but not necessarily predict – its ups and downs.

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At the core of any stock’s value is the “earnings per share” of the company issuing the stock.  Earnings per share is simply the company’s total profits divided by the number of shares of stock issued by the company. The higher the earnings per share, the more profitable is owning the stock. Hence, as earnings per share rise, the stock’s value should rise. In contrast, if earnings per share fall, the stock’s value should fall.

So – you might say – if I just buy stocks whose earnings per share has been rising, then I’ll make money. Unfortunately, that’s not necessarily the case. Past performance of a company is already incorporated – some say “baked in” – to current stock values. Buyers of stocks look to the future for information about how a stock and the stock’s company will perform.  In other words, the stock market is future-oriented.

Understanding this looking-ahead view of stock investors lets us see why the market responded so negatively to the coronavirus. First, the virus appeared out of nowhere. I don’t know of anyone who predicted it. If there was someone, their prediction wasn’t publicized. The coronavirus wasn’t on investors’ radar screens.

Second, viruses are scary things. Each is different and requires its own vaccine. Vaccines take months to develop. In the meantime, the virus can spread, induce illnesses and deaths and cause economies in widely infected countries to almost shut down.

Yet contagious viruses periodically pop up, and those in the past haven’t seemed to affect investors and the stock market so dramatically. So, what is different today?

In a word, the answer is “globalization”. Today, we are a more interconnected world in terms of both trade and travel. China – where the coronavirus was first detected – is considered the world’s manufacturing superpower. Over 28 percent of global manufactured output comes from China, almost twice as in the second-place country, the U.S. This means there’s tremendous worldwide contact with China. Also, Chinese tourists now exceed tourists from any other country in worldwide travel.

Therefore, the essential reason why the stock market took a plunge after the outbreak of the coronavirus is that the virus put a big question mark over the future earnings per share of many companies. Clearly, US companies that trade with China or other countries with major virus outbreaks can be impacted. Shortages of products from China have already occurred, so US companies using or selling Chinese- made products have been affected.

US and North Carolina farmers were expecting increased sales to China as a result of the Phase 1 US-China trade deal signed in December. There’s a good chance those sales will be postponed.   Travel and tourist companies will also take financial hits.

But even companies with no direct ties to international trade can be hurt by the stock market pullback. Investors who have lost money in the stock market now have less wealth. Studies show declines in wealth can translate into declines in spending on many products and services, even those not tied to China or other countries with numerous coronavirus infections.

My point is the stock market is forward-looking, always trying to find clues about what the economic future holds. The coronavirus has put a big cloud over that future. Yet it’s that same forward-looking that could generate a big stock market rebound.

How so, you ask? Prior to the coronavirus outbreak, most forecasters were optimistic about the economy. Production was rising, jobs were being added and wages and incomes were improving.  There were no apparent imbalances in the economy that could trigger a recession.

This means that if the news on the coronavirus goes from bad to good, then the pessimism on Wall Street could quickly turn to optimism. “Good” news about the virus could be many things – such as a reduction in new cases and deaths, the impending development of a vaccine or an evaluation that the symptoms of the virus are not as bad as originally thought.

Such good news would begin to remove the gloom hovering over the economic future and make it clearer for investors to see a positive path. It certainly wouldn’t erase the losses already incurred from the virus, and it may not eliminate all the losses to come. But just for investors to see the future as “less bad” than it could have been would lead to optimism and overall gains, rather than continued losses, in the stock market.

Investing in the stock market can be both rewarding and challenging. A big reason is because stock values today depend on guesses about the future economy, and everything that affects the economy. This is why some people stay out of the market, while others stay in regardless of its ups and downs. You decide which approach is best for you!

Dr. Mike Walden is a William Neal Reynolds Distinguished Professor in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.