These times are crazy. The stock market isn’t. What you should know | Peter Crabb
It’s been crazy.
Since reaching historical highs earlier this year, stock prices have fallen steeply only to rise right back. The Dow Jones Industrial Average is still down slightly for the year, but the Nasdaq has returned to its peak. These are certainly volatile times.
Economic theory generally assumes that investors are rational and that stock and bond prices accurately reflect all current information about these investments. People often raise doubts about these market theories when we experience volatility like we’re seeing now.
Fortunately, economic research can still help explain these big price moves, and current indicators suggest markets may not be as crazy as we think.
Behavioral finance is a branch of economic research that includes psychological studies of investor behavior, such as attitudes toward risk and belief about probabilities.
One psychological factor is that our “pain” from losses exceeds our “joy” from gains. Translating this to investment choices means that we generally take on more risk only after making good gains, and stop taking risks altogether when losses occur. This behavior tends to exacerbate these same trends, making the market more volatile in the short run than it would be otherwise.
A second factor is our beliefs about probabilities. When we witness an event that rarely occurs, we overreact. So behavioral finance teaches us to expect excessive short-term trends and overreactions to events like the COVID-19 shutdowns.
But how much volatility is too much?
A widely cited measure of stock market volatility and risk is the CBOE Market Volatility Index, or VIX. The index reflects the cost of mitigating risk through the sale or purchase of option contracts on large U.S. stocks. This cost rises when prices move dramatically in one direction or another, reflecting greater uncertainty over what prices will be in the future.
The VIX rose to over 80 in mid-March, but quickly fell back under 30 by the end of May, not far from index’s long-run norm of 20.
Two key measures of stock values are also not much out of line. Stocks in the Dow now sell at an average rate of 21 times past earnings and yield over 2.5 percent from dividends. With corporate earnings declining right now, the price-to-earnings ratio of 21 is above normal, but the 2.5 percent dividend yield is in line with the historical average.
The pandemic caught us by surprise, but the market’s not crazy.
Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. prcrabb@nnu.edu