This is why stocks go up
The stock market is not a conspiracy and it's important that we say so.
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And now, why simple questions must be answered.
“Why do stocks go up?”
Out of an abundance of caution, I’ve always tended to answer this question with some version of a smirking “who could say?”
And really, who could.
But there is an answer to this question, the answer is simple, and the answer is in this chart from FactSet.
Stocks go up because investors think corporate profits are going to be higher in the future than they are right now.
Right now, stocks are going up a lot. Last week, the S&P 500 went up each day. And each day, it closed at a record high.
But a common statement of fact you will see from many members of the commentariat these days is that the stock market is disconnected from reality. Or worse: that the stock market’s rise is somehow nefarious, fake, not to be trusted.
It is, of course, understandable how one might reach that conclusion. At least in absence of a more straightforward framework about the stock market.
Because in the real world, more than 1,000 people are dying each day from a virus still spreading in a near-uncontrolled fashion across the country and tens of millions of Americans are out of work and receiving inadequate financial assistance to make ends meet. So why would the value of big American businesses be going higher?
The investment community is not necessarily unconcerned about this real world. It is indeed troubling. But judgements about whether stock prices should be higher or lower are only concerned with these developments insofar as how likely it is these events would change the future direction of corporate profits. The answer today is that these events will not. Profits will be higher.
Obviously, many readers are going to disagree with this outline of 1: why stocks go up and 2: the idea that there can even be a simple, credible answer to the question. Perhaps all readers. Some of you may have thought I was going to say that stocks go up because the Federal Reserve is manipulating markets higher. I am guessing that I’d have a lot more subscribers if I held this view. Or at least pretended to. Which I do not.
And, sure, the Fed is supporting a case for buying equities via its interest rate policy (which makes any fixed income-type investment more closely tied to interest rates less attractive). But that is just one case and an indirect one at that. Corporate profits, in contrast, are a direct case for the value of stocks. The direct basis for the value of stocks, I should say.
Profits accruing to businesses have increased steadily over the last few decades. So have stock prices. After real and expected profits fell sharply in the first two quarters of this year because of the pandemic — which initially lead to a swift, severe market decline — profits are now expected to increase in the year ahead. Stocks have risen in kind. Additionally, in the second quarter of this year profits fell less than expected, adding even more conviction to this view on future profitability.
That profits will not continue rising in the future is a fair objection. The market right now disagrees with this view, but this view makes a sound case for lower equity prices in the future.
In the second half of the last decade, for instance, the tight labor market had started to move leverage away from capital and towards labor, with labor’s share of domestic income rising modestly in the few years before the pandemic. Labor is the biggest cost for most businesses, and a tighter labor market means more competition for workers which means people get paid more. This is good for you and me and not as good for investors. Save for massive corporate tax cuts, the future of corporate profitability looked a bit murky in the mid-’10s. And from the summer of 2014 through the day before Donald Trump was elected president, the S&P 500 went basically nowhere.
Most of the last decade’s labor market gains, however, have vanished with the massive job losses seen during the pandemic. And some Wall Street strategists think labor’s loss of leverage right now will help fuel future profits and, in turn, is part of what is pushing stocks higher today.
Now, the exact level of the stock market — i.e., the price of each stock and the index itself — reflects not just the level of corporate profits but the premium investors will pay for these profits. You could say the market’s high valuation today implies fewer concerns from investors about corporate health in the future, but you don’t have to say this. All the multiple says is what investors are willing to pay for a dollar of corporate profits.
This measure has risen and fallen over time. Right now, the market’s multiple is high relative to history. But there is no rule that says stocks must trade at a certain valuation, now or ever. There is no abstract framework against which to say stocks are “expensive” other than a very limited historical data set that is somewhere between dangerous and useless to imply contains a “true” fair value or whatever math-envy type grounding investors think exists in equity prices. The multiple is just the multiple.
So whether stocks will continue going up, what my view on the technical or fundamental soundness of the current market is, or how certain sectors are likely to benefit from the broad rollout of an efficacious COVID vaccine in the second quarter of 2021 doesn’t really matter. What matters is that investors, in the aggregate, think corporate profits will be in better shape in one year than they are right now.
Answers to these more complicated questions can be found in lots of other places. None of the answers offered, however, are much more than guesses.
But it’s important to construct a simple, straightforward explanation of why the stock market does what it does because overly complicated or conspiratorial answers are so often at close reach. And because popular confusions or misunderstandings about what drives the stock market only empower these sorts of pseudo explanations.
And this extends beyond the market, of course. We must always press for — and demand, and get — simple answers to big questions because they are both available and because they offer the only real defense against YouTube-style conspiracies that Explain Everything.
And we’re too often conditioned to believe that simple questions about big topics need not be asked and answered, as we saw this week on Twitter when a video of a young woman asking questions about math went viral.
The questions included, but were not limited to:
How did the people who discovered math know they were discovering math?
How did these people know they were right?
Why are men being weird on the internet?
Obviously, I do not know the answers to these questions. Or at least, the math questions. But I would like to know them!
So but the video’s premise, at least as far as I can tell, is that there are some simple questions about math we never even approach answering despite math being a core part of what we learn in school. (And in the mind of many folks, the most important thing we learn in school.)
Math’s importance is so great that in 2020, a longshot presidential candidate made it to the final Democratic debate of the primary cycle with the slogan “M.A.T.H.” — Make America Think Harder. And, yes, Andrew Yang’s invocation of mathematics is just like calls to vote: an anodyne statement that educated center-left(ish) voters want to hear more of because they just cannot be bothered by the messiness of our politics. But that Yang’s pivot to politics could be propelled by just saying “math” a lot shows how important the public believes understanding the subject is for having an informed populace.
Which, okay. Yes. But just like calls for “financial literacy,” it’s not clear to me that “knowing math” really does anything for anyone given that we have undertaxed elites who control a politico-corporate power structure that seeks to harden our growing inequalities, but sure. Math. But this post is not about pedagogy. Please send your complaints and ideas about math curricula to your local school board.
But so asking “Why does math work” is basically asking “Why do stocks go up.” It would seem like there ought to be a simple answer to this question. And indeed there is (are). And yet it is out of a mistaken belief that if these answers really were available we’d know them already — or that trying to answer a question as simple as “why is the stock market higher” might not be possible — that these conversations elude us.
As Gracie Cunningham notes in her video, actual mathematicians and physicists are being nice and trying to answer in the replies while people who don’t really know anything are calling her stupid. Complexity serves the under-informed and the powerful. And this, of course, is often the same constituency.
And as someone who wandered into a credential-laden world like finance as an outsider with no credentials who really didn’t (doesn’t) know anything about anything, I will always support a kind of “simplicity for all” framework. Mostly because it has always been the simplest answers that have saved me from making the biggest analytical errors.
That there are endless caveats and “but alsos” in explaining any baseline concept about financial markets, corporate earnings, capital structure, and so on is not to be ignored. And indeed, understanding these conditionals helps inform these pat answers to big questions. But it is from the seeds of this complexity that misunderstandings and, later, conspiracies grow. And so we should not allow ourselves, in markets, math, or otherwise, to let academic or industry infighting about the specifics of a simple idea keep that idea out of the public’s understanding, whether this omission be malicious or not.
And this approach ought to extend to any area in which expert knowledge allegedly makes straightforward answers impossible and the public is told to accept that simple questions can’t be answered. Questions like: why don’t we have affordable healthcare for all Americans? Or: why does Apple get to book profits in Ireland and avoid U.S. taxes?
Anything as foundational as why math works, why my healthcare stinks, and why stocks go up must be explicable to a non-expert audience, lest the more popular answers start crafting a unified theory about why we can’t have nice things. Because it is in these answers that we draw lines between real world solutions, real world facts, and the conspiracies and alternate realities we see in bloom all around us.
And if all you offer those asking is an assertion that it’s complicated, your audience will find a simple answer elsewhere. And it is in these elsewhere’s that deeper problems lie.
: I read a lot of the replies and… I’m still not entirely sure what the answers are but there were many earnest attempts at a helpful answer. Heartening!
: Unlike financial services, however, the world of math education is well-meaning. The inability for school lesson plans to devote considerable time to “explaining why math works” is only hamstrung by students and teachers having a finite amount of time to learn long division, trigonometry, and literally everything else. It is not because educators want to hoard this knowledge for themselves that so many students finish school without having a clean answer for why math works. This is not true in finance.