on the 20th of march 2020 the s p 500 index fell to 2 300 points from a previous record high of
nearly 3 400 points which was reached just a month earlier there was a very good reason for this it
had become obvious that the covert 19 pandemic would not be contained to china and case numbers
throughout europe and america were swelling into the hundreds of thousands the stock market is an
infinitely complex entity and some of the most brilliant people in the world dedicate their
entire lives to predicting its movements most with little success but there is a general rule that
most investors agree on if people are optimistic about the future the stock market will rise as
people want to put their money in a position where they can cash in on that optimistic outcome
if people are pessimistic about the future the opposite happens people pull their money out of
the market in case they lose their job or in case they need to support their business or just in
case there's an opportunity to buy back into the market at a lower price once it has crashed in
march of 2020 most people were understandably on team pessimism which is why it came as no surprise
that the stock market experienced one of its most intense downturns ever losing 30 of its value over
a month in the two years that followed the news hasn't been much better for the businesses that
make up this index there have been short-term fixes not least of which was huge quantitative
easing and corporate bond buying initiatives from the reserve bank coupled with fiscal stimulus from
the federal government but those were by their nature a temporary fix life support if you will
for businesses who probably shouldn't have been expected to plan for a one in 100 year event like
this these fixes are also very likely coming to an end the political will to continue to support
private companies is waning and inflationary pressures are forcing the fed's hand into tapering
their expansionary monetary policy despite this the world is not in a much better position than
it was two years ago labour shortages supply chain issues threatened tax changes or to say
nothing of case numbers that make 2020 look like a warm up despite this the s p 500 index
was up by over 100 from its low in march of 2020 that represents the single most intense bull run
in american financial history leaving many people on the sidelines thinking what is going on here
it's perhaps not coming as a huge surprise to those same people that the market looks like it
is finally heading in the opposite direction as of writing this video the s p 500 is down almost 10
from where it started this month similar downturns have been felt in other major securities in crypto
markets and many are expecting this to overflow into less liquid assets like real estate so it
was just one question for this video is this the inevitable financial downturn that we should have
had two years ago we have seen that governments are remarkably capable of keeping an economy on
life support but perhaps that only delays the inevitable when they are forced to pull the plug
now as always when discussing financial markets it's time for the big disclaimer this is a
developing issue and there is a very real chance that markets will be back to all-time highs before
i finish writing recording and editing this video we are not here to make predictions about
the future we are here to try and make sense of the present while learning a thing or two about
economics as we go i have not personally changed my investment strategy which is simply putting
away a set amount of money every month into a low cost index fund and paying off the mortgage to an
investment property but with that out of the way to understand the fall we must first understand
the rise stocks simply represent an ownership stake in a company they normally allow investors
to vote on issues within the company and most importantly they allow investors to share in
the profits distributed from that company this has historically been done through dividends
if a company has a net profit after tax and nothing better to do with that money they
will pay it out to their shareholders if you are a ceo giving money to your shareholders consistently
is also a great way to stop them from voting you out there is also another way that companies
can return money directly to their investors and that's through share buybacks again if a company
finds that it has profit left over after tax it can use that money to buy back its own shares in
public markets this only directly gives money to the shareholders who decide to sell their shares
back to the company but it indirectly increases the value of everyone else's shares which to
many investors is actually preferable because you don't pay tax on appreciating share values
you do pay tax on dividends though of course all of this relies on companies actually having money
left over after paying costs expenses and taxes some of the largest companies in the world are
famous for going very long periods without ever turning a profit meaning there were no chances
for dividends or stock buybacks investors were still happy to invest in these companies though
because there was the chance that given enough time and money they could turn into corporate
behemoths capable of making more money than an average company could ever dream of sometimes this
strategy pays off and sometimes it doesn't i am sure most of you already know all of this but it's
important to really keep in mind while we try to make sense of the market over the past few months
there are a few companies that have genuinely benefited from lockdowns food delivery services
online shopping retailers streaming companies and social media platforms being the most obvious
we were stuck at home and we needed something to do to pass the time while having stuff delivered
to us these companies have not only benefited from a new captive audience but they've also had a new
very profitable market open up to them remote working systems were needed and fast fortunately
these companies were there to provide an array of solutions software as a service to business is
incredibly profitable large companies can pay tens of thousands of dollars a month for enterprise
software which enables them to let their employees work from home look at the revenue of a company
like microsoft and their growth explodes in 2021 thanks largely to the digital infrastructure they
give to businesses now obviously not all companies have been so lucky but that hasn't really mattered
the growth in the big headline indexes like the s p 500 and the dow jones have mostly been fueled by
a dozen or so of the largest companies in the world because these companies are so large they
take up a disproportionate amount of the indexes which are weighted by market capitalization
of the 10 largest companies in the s p 500 seven of them are tech companies one is tesla which is
kind of a tech company one is berkshire hathaway which is a holding company comprised of almost 50
apple shares and the last one is johnson johnson which isn't a tech company but has also not been
having a bad year just these 10 companies comprise over a quarter of the weighted value of the s p
500 if these companies do well it almost doesn't matter what the rest of the market is doing
this is a chart of the s p 500 in the months after the initial downturn the performance of the top 10
stocks recovered within two months while the remaining 490 companies lagged behind their
previous peak until the end of 2020 another way to look at this is to exclude all tech companies
from the index which makes the most intense stock rally in history look rather tame in comparison
many stocks especially those of companies in affected industries have not recovered at all tech
and healthcare have done well everything else was just along for the ride we actually explored this
further in our video on why the stock market is at an all-time high of course that's not the whole
story despite these large companies doing well for themselves in the pandemic the total earnings
of all public companies was still down in 2020 fortunately tech had an ace up at sleeve yet again
because investors naturally expect lower returns from this industry price to earnings ratios track
as the name might suggest how much a company is worth over how much the company earns normally
broken down to individual shares a company that generated huge profits but for some reason has a
very low market valuation would have a very low p e ratio a p e ratio of five for example means that
a company would generate its market cap in profits every five years hypothetically if the company
distributed all of those profits as dividends an investor could earn back their investment
in those five years without even needing to touch the underlying shares some companies
especially technology companies have much higher pe ratios tesla for example has a p e ratio of 303
meaning that it would take the company 303 years at their current net income to pay out the value
of their shares for context the price to earnings ratio of general motors is seven and that's high
by historical standards if you think that's bad there are a lot of public companies that currently
make no profit at all meaning their p e ratios are practically infinite investors are happy to accept
these higher p e ratios for a few reasons the first is if they think the company has a strong
potential for future growth a company like amazon didn't turn a profit at all for more than a decade
but its investors happily kept on throwing money towards it because they saw the potential it had
to become the online shopping juggernaut it is today the second reason is because a stock
might have intrinsic value beyond its ability to make money in the short term facebook acquired
instagram for an extremely high price to earnings ratio because the synergy of the two brands was
worth more than the individual company operating alone the third reason is because they have no
better option which is really the one that we need to focus on as it relates to the market rally of
2020 and 2021. one of the big things the federal reserve bank did during this time was buying up
lots and lots of corporate bonds from american companies this art officially drove up demand
for corporate bonds which lowered their yields if a bond sells on the open market for
a hundred dollars and pays ten dollars in interest every year then it has a ten percent yield if the
fed comes along buying up all of these bonds and drives the market price up to a thousand dollars
then that 10 interest payment would only represent a one percent yield bond traders try really hard
to make this sound more complex than it needs to be but that's basically what happened investment
grade bond yields collapsed at the same time that people were starting to worry about inflation
it's no good earning four percent interest on your investments if inflation is five percent so what
were investors to do they could pull out of the market entirely but then they would still have the
same problems with inflation which really meant their only option was to buy shares no matter
how overpriced they were since the gfc the s p 500 has averaged a price to earnings ratio of around
20 meaning that earnings of all the companies in the index would take 20 years to equal the market
cap of the index in 2020 p e ratios spike to over 35 because companies were making less money while
demanding higher valuations because investors had nowhere else left to go these factors combined
with a significantly higher household savings rate and you know let's be honest the fear of missing
out on the mother of all bull runs to give us the mother of all bull runs
so then what has changed now for a while the stock market rally almost looked like it was making
sense vaccine rollouts meant that there was the hope of life getting back to normal unfortunately
that hasn't necessarily played out exactly like we may have hoped and markets have started to realize
that this will be an issue that well outlives the government stimulus measures designed to
get businesses through it if there was a time to reconsider the market's reliance on easy money
it was going to be last week as the fed met to discuss its monetary game plan in the new year
market anxiety around this meeting saw a lot of investors pull out of their positions so that they
had the cash ready to put towards either stocks or bonds depending on which way the fed went on
interest rates power would later announce in a press conference that interest rates would remain
on hold at zero percent which gave the market a slight boost as investors got back on board
the cheap money bandwagon this rally was later reversed when the fed chairman went on to answer
questions about inflation and future plans for interest rates they acknowledged that inflation
had become a concern and that they would likely be raising rates in march or april to combat this
issue they also made it very clear that corporate bond buying would stop and actually be reversed as
they try to sell off their newly acquired holdings over the coming years these announcements probably
shouldn't have been a huge surprise but by this point the market had enough inertia that even the
confirmation of bad news was enough to sustain the daily declines regular viewers of the channel will
probably know what i'm gonna say next investors love nothing more than stability and confidence
the last two years have undoubtedly had a massive negative impact on the global economy
but the government and the fed did a really good job of publicly displaying that they would
protect businesses from the fallout was this worth the price that they paid well maybe not
but nobody is arguing that it didn't give confidence to market participants
the same confidence just isn't here in 2022 the stock market is not the economy and the economy
is not the stock market they are correlated but one doing well does not mean the other can't do
poorly we have seen the economy do poorly while the stock market has done well now the economic
metrics are looking up we might start to see the stock market go in the other direction potentially
the biggest factor here is the hardest to quantify human nature i'm sure there are many investors out
there that were baffled by the market rally experienced over the past two years and have
almost convinced themselves that a correction is inevitable once they see a few big red days they
will sell their positions to either stop the losses or to try buy back in at a lower price
unfortunately this doesn't usually work out the way they expect it to in the long term this is
probably for the best good investors should have a time horizon measured in decades rather than days
so think of this as an opportunity to buy the same companies from two weeks ago at a 10 discount