The difference between the performance of capital markets and the general economy, especially the unemployment rate, has raised many questions and made markets seem to be illusory. In some ways this is a reasonable perception. As usual, other perspectives can yield more satisfying explanations.
Not all companies perform equally in their stock market prices. The environment and events of the moment have large effect. Market prices have shown us that certain companies have benefited from the way society has changed during the COVID-19 crisis. A group of tech-focused businesses, referred to as FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks, have seen their share values increase in ways that are challenging to put in perspective.
Not surprisingly, some professors of finance have examined the situation and offered comments. One such professor, Gene Fama, Nobel Laureate at the University of Chicago, has some cogent observations, which I summarize next.
First note that these firms are entirely different from one another. They are the end result of a process that started before 2000. At that time, hundreds, even thousands, of companies in various aspects of tech were emerging and competing. Most of those companies did not survive. Indeed, we may have trouble even remembering their names. These five boiled to the top, so we tend to concentrate on them and forget about the fact that most of this industry died.
If you tried back then to choose who would be the winners, you probably have an empty sack today. Basically we now have only the survivors, which have thrived, especially in the current unique economic situation. But that does not mean they will continue to do well, or anything close to the phenomenal returns of last year. Such numbers are far above any reasonable expected return.
Despite warnings for what is reasonable, stocks with lofty returns are alluring to investors. They are the “shiny” idea of the moment. This is because extreme events do occur occasionally, albeit infrequently. Academic research has shown that there are many more extremely good and extremely bad returns than you might reasonably expect. Actually Fama wrote about such occurrences in his dissertation 50 years ago. These surprises have been around with relative high frequency for as long as there have been data.
Another eminent professor, Ken French from Dartmouth, has offered additional thoughts. Market returns are composed of two parts: 1) the expected part; if you are looking forward, that is your best guess of what is likely to happen; 2) the unexpected part, the surprise, the deviation from your best guess.
If we look at a relatively short period and try to draw conclusions, we can be misled by events of the moment. Please note that academic researchers consider short periods to be quite long, longer than most people and certainly the media consider long; five years is considered extremely short.
When investors try to infer meaningful investment decisions from random stock returns, they are fooling themselves. Professor French states that the best example he has right now are the FAANG stocks.
The search for what are reasonable expected returns has been a long term project in the academic world. The results are more elusive than definite. Yet we must deal with making our personal decisions in the face of uncertainty. Too often we are bombarded with talk about unexpected returns, whether extremely good or extremely poor. FAANG stocks may make up part of a well-diversified portfolio. But a well-diversified portfolio is much more than those five stocks. That is why it is so important not to fall for the siren songs of the flashy extreme events of the moment.