Rising stock prices during a worldwide crisis: can this be explained?

Studio Erasmus
Erasmus School of Economics
Erasmus School of Economics

The world economy took a huge hit last year, but stock prices are higher than ever. Everyone from young to old has started investing and the market continues to rise. Is the stock market on the verge of collapse? And how can we explain the current trend in the stock market? These questions and more are answered by Patrick Verwijmeren, Professor of Corporate Finance at Erasmus School of Economics, in Studio Erasmus.

Good return against a low risk

Verwijmeren explains that investing for the long term gives you a good return against a relatively low risk. 'What investing is all about is getting as much profit as possible at the lowest possible risk. If you invest, the average return is higher: about 6 to 8% per year. This, of course, fluctuates from year to year but in the long run you can estimate the return quite well.’ By looking at past trends we can estimate what the return will be in 10 to 20 years. The difference between 6% or nothing is very big in the long run. In addition, compound interest causes an exponential increase in your investments: if you get a 6% return every year, your money rises faster and faster.

Investing vs. speculating

According to Verwijmeren, you should really separate investing and speculating. ‘When talking about investing it's really about spreading your risk: you invest in different shares and make sure that these investments are not too interrelated. As a result, your risk is a little lower and you can best predict what it will do over the long term.' He explains that a few companies might fall, but that can be offset by other investments.

'Speculating is for the short term and the risk is often much higher,' says Verwijmeren. 'With speculating, you invest in a single stock or Bitcoin, for example. If you really speculate you hope, for example, that in a few months you can already sell your investment for a higher price. With stocks, you also don't know what the stock price will be next year. But if you invest for the long term in a diversified way, you can estimate what the return is going to be relatively well.'

Quick market response

'When we talk about why we can't predict what a stock is going to do in the short term, and why I can't tell you to be in Heineken or Bitcoin, it's because all the information that's available is already built into the price’, Verwijmeren explains. The stock price reacts very quickly when there is news. This could be seen in the 1980s when the Challenger Space shuttle exploded. At first it was unclear why it exploded and which company was responsible. If you look at the stock prices of that time, you can actually see that the prices of all the supplying companies immediately dropped. Within an hour however, all shares stopped dropping except for the shares of one company. This company kept dropping and lost more and more value. Months later it turned out that this was indeed the company that had supplied the part that caused the explosion. The market caught on very quickly.

A rational explanation 

You now see that the economy is having a hard time while stock prices keep rising. When the pandemic broke out, you initially saw the stock market collapsing, but then it recovered very quickly. Why are share prices still so high with the current state of the economy? According to Verwijmeren, the current market trends can still be explained in some sense. ‘A share price is related to the value of a company, and the value of a company is very much related to all future profits. Maybe a company has less profit now for a year or 2 but if it's still going to generate a lot of profit in the future, then the share price should still be high. Maybe the prices are also high now because we see how strongly governments are intervening. That is actually a signal for the future that if things are going badly for a while and companies are in danger of collapsing, the government will intervene. So there is actually a rational explanation there.'

More information

The full item from Studio Erasmus, 23 April 2021, can be found here (in Dutch).