US Stock Market and Inflation rate
You may know that recently the US stock market crashed down in a short period of time and tied up many investors’ money in the market who bought at very high prices. The main cause of that was because the US economy is expected to be impacted by very high inflation rate. The US recorded about 8.5% inflation rate for Mar 2022, that’s very high. So why inflation would push down the stock market?
Risk and return
When inflation rate is high the US federal reserve bank will increase interest rate to bring up the interest rates in all major US banks so that its citizens would keep money in the bank for earning interest instead of spending it to further over heat the economy. All stock valuation is based on comparing “rate of return of stocks” with the “risk free investment” like bank deposit, so when interest rate goes up the expectation on rate of return of stock also goes up, because investor always need an additional premium return as stock is more risky to invest than depositing money in the bank. For example, if an investor gets 1% interest from a bank, then he/she needs 1% plus "extra % premium" return for stock. That’s called risk vs return balance.
How investors valuate a stock?
The stock valuation can be calculated by this simple formula called the dividend growth model shown below:
Value of a stock = D/(Rs-G)
Where
D is the dividend per year investor get from holding the shares
Rs is the rate of return of stock per year (it is an expectation from investors)
G is the growth rate of the dividend per year
Looking at the formula you can see when the rate of return of stock goes up the value of stock goes down. It is a chain effect, inflation bring ups interest rate and then brings up rate of return expectation of stock and then bring down the stock value or stock price. That was the chain effect of inflation on the US stock market.
The US stock market falls down rapidly also because it was at an extreme high level too. During the last few years the US government injected a lot of money into the financial market to prevent an economic collapse due to COVID 19. Also many people were forced to stay home and use technology for their daily life and work, and resulted revenue growth for many technology stocks.
If you look at the above dividend growth model the bigger the growth rate the smaller the denominator it is, so it will propel the stock valuation to a very high level. In any stock market when it reach a critical height it will always fall back down to the normal level when people start to realise the fundamentals of stock valuation instead of being irrational, many expert investors said that the stock market valuation in the last few years has been deviating from the normal level way too far, like 1 in a 100 years due to historical low interest rate and low inflation.
Market Imperfections
One would argued that if every stock investor act rationally according to the formula (Dividend growth model given above) then the stock market should behave perfectly, and stock prices must be exactly what the formula predicts. But in reality, we know it is not, this is what economists called market imperfections. One of the biggest imperfections is the asymmetry of information. Institutional investors on average often beat small retail investors because they have more real information to analyse the market situation. The people who are well connected to the public listed companies may know the inside information of the company performance better than anyone else, although there are laws to prevent insider trading, but these people able to make an earlier move than others legally. Also, small retail investors are often irrational due to greed, ignorance and have limited real facts to judge and react fast enough.
But having said that, during this recent market crash many small investors were trapped at the peak prices, they often trade with a mobile app named “Robinhood”. So, if they have understood the above concepts and fundamentals of economics discussed, they would still have time to escape this crash at an early stage and saved a lot of money.
