Why emotion might be driving the market during COVID-19

The ASX keeps rising, temping out new investors. But sentiment is a significant driver of market performance. We can see this in situations where despite a poor profit result, the price of a company’s shares can increase.

It might be because investors thought the result was going to be worse than it was. Maybe investors were particularly happy about the economy generally and so decided to place a premium on the price of all shares.

It is difficult to trade shares on a short term basis as a result of these seemingly illogical reactions. The fundamental value of a company can be overinflated by the market, or its true value may not be reflected in its price, merely because of how people are feeling on a particular day.

There are a few more reasons why we sometimes see market movements which, on the face of it, appear counter to what we would expect.

Perhaps these are why the market is rising during COVID-19:

1. The market quickly prices in expectations of bad news

There is a long lag between actual events and the release of economic data. In Australia, a negative quarter of GDP growth for the March quarter (an early indicator of what many see as the inevitable economic recession) was confirmed last week, nearly two months after the period the data is reflective of. The market had expected this result for a long time. It could be argued that expectations were of a larger decline, so the market reacted quite positively.

2. Uncertainty weighs more heavily than bad news

The market will typically react most unfavourably when news which is unexpected is released. In the current environment, everyone expects business conditions to be difficult so that sentiment is already reflected in prices.

3. There are no ready alternatives for investors

With interest rate and bond yields at historic lows, investors have really no alternative than to continue to buy and hold shares. Demand for quality share investments has a positive impact on the overall market.

4. The market not only looks forward, it looks forward a long way

A short term decline in company profits or more particularly a decline in cash flows from companies is not really important when the market is assessing value. As investors we look for sustainable positive cash flow over a long period of time underpins market estimations of the value of shares. If the market believes a company’s prospects are likely to return to positive over the medium term, it will look upon that company favourably and not discount the value for a relatively short term impact due to current economic conditions.

5. Government stimulus is helping to improve company prospects

In Australia and around the world governments have injected vast amounts of money into the economy. They have done this in an effort to minimise the impacts of imposed economic slowdowns on businesses. This stimulus provides a level of comfort that companies will survive the crisis and hence the market prices shares accordingly. Without this stimulus, investors would likely have a more cautious view as to which companies they invest in.

There remains significant volatility in markets and nobody knows where it will end up. We don’t know whether increases in share values will continue or whether we can expect yet another decline. No one can tell why the market is rising during COVID-19. Sometimes the market falls when we least expect it and other times it rises to our surprise.

We have no choice but to hold to our strategy, recognising that there will be ups and downs, and try hard not to lose sleep.