Investors: You’re Looking at the Stock Market “Rally” All Wrong

Market volatility is masking what’s really happening.

This article originally appears on the Motley Fool by Dan Caplinger

Around the world, the coronavirus pandemic has had a huge impact on people’s lives. Although only a small portion of the global population has contracted COVID-19, the massive responses to try to slow its spread have caused economic disruptions of a scale not seen in nearly a century. More than 30 million Americans have filed for unemployment benefits just since mid-March, and millions more are likely to do so in the coming weeks and months.

Amid this ugly landscape, many people are completely confused by the rise in the stock market. Between March 23 and April 29, the S&P 500 (NYSEARCA:VOO) soared more than 30%. Some market participants attribute the apparent disconnect to unjustified optimism, with investors discounting the gravity of the coronavirus crisis and its likely long-term impact on the economy and the stock market.

However, it’s misleading to look only at the market’s rebound without putting it into the context of the plunge that preceded it. Only by looking at the net impact on the stock market can you accurately gauge true investor sentiment and what people expect in the future. What that net impact shows is a lot more nervousness than you’d think from just looking at the recent rally.

The total impact of coronavirus on the stock market

On Feb. 19, there were 15 reported coronavirus cases in the U.S, and the stock market hit a new all-time high. Although roughly 75,000 Chinese residents had contracted COVID-19, new case reports were starting to slow, and many investors discounted the shutdown of much of the Chinese economy as a short-term phenomenon with international consequences only for manufacturing supply chains.

In the ensuing weeks, the S&P 500 plunged 1,150 points. Despite case counts coming under control in China, the spread of COVID-19 to South Korea showed that the disease hadn’t been contained within China’s borders. In the weeks that followed, case counts climbed exponentially in the U.S. and Europe, and most of the world imposed stark restrictions on travel, business activity, and public gatherings to try to minimize further exposure to the pandemic.

When you look at the stock market recovery that followed the drop, the S&P clawed back about 700 points of its losses. However, that still left the index down 450 points from its highs, or roughly 13%.

What’s a lost year worth?

That leaves a simple question: Does all the damage that the coronavirus pandemic has wrought justify a decline of just 13%, or are investors being too rosy in their outlook?

Obviously, only hindsight will give a perfect answer to that question. However, one method called the discounted cash flow model, which many investors use to establish valuations for stocks, can give some guidance about whether a decline of this magnitude is appropriate.

Under this method, the value of a stock is equal to the present value of all of its future cash flows. Income further in the future gets discounted to a greater extent than income expected sooner, using a discount rate to reflect the time value of money.

So to keep things as simple as possible, let’s make some assumptions. Say that you own a stock that consistently has income of $100 per share each year. To be conservative, you’ll only count on it doing so for the next 10 years, and you use a discount rate of 10%.

Based on a simple discounted cash flow valuation model, that stock would have a value of $714 per share. The first year’s income of $100 wouldn’t get discounted, but the following year’s $100 would only have a present value of $91. Following years would add $83, $75, and so on.

Now, say that a pandemic completely wipes out that first year’s worth of earnings. However, you believe that after the pandemic ends, things will go back to normal, and the company will be able to bring in the full $100 for the rest of the decade. Under those assumptions, the value of the stock would fall to $614 — or a decline of 14%.

Waiting for the answer

It’s no coincidence that the 14% drop under discounted cash flow analysis so closely matches the stock market’s net 13% drop. However, the assumptions aren’t realistic. Economic activity hasn’t completely ceased even now, and it could take years for the economy to get fully back to pre-coronavirus levels.

The point, though, is that as painful as near-term estimates of declining revenue and earnings are for stocks right now, they don’t have as big an impact on long-term valuations as you might expect. The key is for companies to find their way back to viable growth trajectories that match their previous opportunities. In some consumer-facing industries that rely on a healthy jobs environment, that might not happen, and stocks in those sectors could suffer greater losses as a result.

For instance, the airline industry has come to a near-standstill in recent months, as international and domestic travel restrictions and nervous passengers have combined to push demand toward zero. Other travel and leisure businesses, such as cruise line operators, movie theater companies, and hotel owners, have seen similar plunges in business activity. For them, it could take a lot longer for earnings to return to what they were before the outbreak hit.

Yet other individual companies might escape nearly unscathed. Indeed, a select few will find new opportunities emerge that let them expand their businesses in ways they never would’ve had the chance to do without the pandemic. We’ve already seen that with companies like Zoom Video Communications (NASDAQ:ZM), whose video collaboration platform has become the standard for personal, business, and educational use almost overnight.

What to do

Now more than ever, investors have to respond to difficult times by suppressing their kneejerk emotional responses. Those who succumbed to the extreme pessimism at the bottom of the recent crash have missed the rebound that followed, while suffering from the fear of missing out on a stock market rally might overly discount the risks that could send stocks lower once again at any time.

It’s likely that massive unemployment will push the economy into recession. But if the impact of the coronavirus is truly short-term in nature, then rebounding demand will send many of those laid-off employees back to work. In that case, 2020 might prove to be a lost year, but 2021 could look a lot more like 2019 than anyone can imagine right now. That’d make the 13% that the stock market has lost seem a lot closer to the right number.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in stocks mentioned above. Read our full disclosure policy here.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Zoom Video Communications and recommends the following options: short May 2020 $120 calls on Zoom Video Communications. The Motley Fool has a disclosure policy.