Why the Stock Market is not overpriced

As of 10:30 am today, May 18, all of the major indices are in rally mode, with the SPX 2941.36 (+2.71%), NDX 100 9318.90 (+1.82%) and the DJIA 24,403 (+3.04%).

Early this morning, the three major indices were moving nicely higher, on the basis of improving virus news and Chairman Powell's interview on 60 Minutes on Sunday night, until news was released later in the pre-market period that Moderna (Ticker: MRNA) had positive early stage test results for its coronavirus vaccine.  Since that point in the time, the three major indexes have roughly doubled their gains for the day.

Recent Economic news can only be described as terrible:
      1. Industrial production -- lowest since 1919
      2. Retail Sales: April -16%,  far worse than the reduced expectations
      3. Continuing jobless claims: over 22 million
      4. First-Time unemployment claims: over 36 million in just eight weeks.

Within the last week, various stock market "experts", including Warren Buffett, David Tepper, Stanley Druckenmiller, and Ray Dalio, have said that the "market is overvalued".  You have to respect these opinions since all of the aforementioned are real investors.  In addition, many of the TV "experts" (not investing their own money) including the widely respected Mohamed El-Erian, have chimed in.  As a lowly finance professor, also investing my own money, I must say that I disagree with this conventional theme that the markets are overvalued.   I am not saying that the "market is cheap" but that generally stocks are fairly valued given the environment and expectations.

 Many are asking how can the stock market be going up (although it is still below the pre-virus levels) given the terrible economic news?

I assert that all of these things make sense.

It is a market of stocks, not a stock market.  Lets take a deeper look at market price dynamics.

Lets go back to fundamental principles as taught by every major business school in the world. 
First, the market is a discounting mechanism that looks to the future--specifically future estimated cash flows.  These cash flows can be in the form of dividends + stock repurchases, or implied dividends (using a variety of financial models, but the residual income model is the basic version).  Second, the indexes are constructed by either market cap weighted (SPX, NDX) or price-weighted (DJIA).  Index construction has an important impact on the movement of the index. 

Looking at the performance YTD of the indices, we see 3 very different pictures of the "market".  The NDX is up 1.02%, the SPX is -9.3%, and the DJIA lags down -15.1% (all YTD, without dividends).  These levels are well above the lows of mid March. For instance, the SPX dropped about 33% in the Mid-March decline and has recovered about two-thirds of that decline. Our first conclusion is that nobody should be talking about the "market" without specifying an index.  How do we explain this rather shocking divergence among the indices? 

It comes back to the impact of the virus on future cash flows.  The market is differentiating among three categories of firms: (1) those firms not affected by the Pandemic induced Lockdowns, or even positively affected by the "shelter in place" orders (examples: ZM & NFLX), (2) those that are currently impacted but perceived as recovering early after the Lockdown is ended (eg. DIS, SBUX); and (3) those that will not recover for some time (airlines, hotels, cruise ships, movie theaters etc).  Take this matrix and apply it to the indices.  The NDX is a market cap weighted index and the largest five firms account for over 40% of the index: MSFT (+15%), AAPL (+4.6%), AMZN (+31%), FB (4.4%) & GOOG (3.6%).  What do these firms have in common?  They are all less affected by the virus (MSFT & AMZN)  or perceived as recovering sooner (AAPL).  Lets take MSFT as an example:  its sources of revenue are its legacy businesses of windows, and Office, and its newer business of data centers.  None of these are very affected by the virus, and its cash flows are growing.  When we look at the SPX, the same firms account for about 20% of the index. In other words, 495 other stocks account for 80% of the index but this group includes airlines, cruise lines and hotels, all of which are 30-50% below their pre-virus highs.  The DJIA is down more because it is price weighted and affected by the sharp declines in BA (63%), RTX (40%) JPM (38%)  Dow (34%), AXP (34%) XOM (32%), WAG (34%) CVX (25%), GS (25%) and 3M (21%). 

As an investor, it is time to place your bets:  Which firms are going to recover faster post Lockdown? Which firms will lag?  Is the market too optimistic about the laggards?  The thesis of the "experts" is that the "market" is too optimistic.  But the laggards are well below their pre-virus levels.  Examples:  DAL (-63%), LUV (-50%) , MAR (-39.5%), HLT (-33.1%), are all far below their pre-virus levels. 

If we look at the leaders for the year, including SHOP, ZM, NFLX, NVDA, PDD, SRNE, BTAI, NVAX, MRNA, and DOCU, it is easy to complain that their prices are too high and that too much credit is already incorporated into the prices for future growth.  This is the group that is probably legitimately susceptible of the "1997" critique: good ideas, and even good firms, but much too expensive.  A good portion of these firms are engaged in the development of revolutionary pharmaceutical products.  These tend to be binary bets with a lot of downside risk.  Fair enough to say that the stock of these firms are overvalued.

My point is that there is a tier of stocks that are growing fast, and have very attractive prospects, but are priced at levels that seem much too high.  But many other stocks seem appropriately priced for the current environment, and the inherent risk to their future cash flows, and these are the largest stocks that drive the indices.  Can we have a correction?  Of course, and at any time for any reason, or for no reason.  Nevertheless, my conclusion is that the "market" is fairly priced--not cheap, but not expensive.