By Dr. Ahmed Badreldin

The disentanglement of financial markets from the real economy has never been more obvious than during the current COVID-19 induced economic downturn.

Countries and international institutions all predict large drops in GDP, with lockdowns, border closures and infection number increases pointing to a continuance of this trend for the foreseeable future.

Nevertheless, stock indices are all rising. This has already been explained by a number of news articles as the effect of increased money from government aid programs that are ending up in the financial markets,
pushing prices up.

What remains to some extent not discussed, is “what does this say about the rationality of financial investors’?”

Thought Exercise:

Put yourself in an investor’s shoes right now: You know the economy is taking a hit, GDP has fallen and will fall further, tourism is postponed for the foreseeable future, and almost all companies are witnessing drops in revenues, layoffs, and may require public aid (if not already so). How can a rational response to all this possibly be:

let’s invest more money into these companies.

Hypothesized Reasoning:

1- “Let’s buy cheap.”

Rationale: Investors assume this is the end of the drop, and therefore a good chance to buy some stocks cheap and ride them on their way up after the crisis.

Problem: Why assume that the end is reached, while all signs are not pointing to that? Why assume that these stocks won’t continue falling further? and finally, Why assume they will recover at all?

Possible answer: Thanks to the repeated “too big to fail” policies witnessed in the recent past, investors have become aware that governments do not want financial markets to burst. With an understanding that – in a time of low interest rates – most pension funds invest their money in financial markets, letting the market tumble will basically throw all future pensioners on government payrolls or worse. Investors are therefore not really betting on the companies they are buying, or the recovery from COVID, but are actually betting on governments to keep doing what they have become known to do.

Evidence of this is in abundance with many central banks expanding their bond purchase programs or different versions thereof.

2- “Just can’t stop!” or “Give me one last chance!”

Rationale: Some investors are aware that fall is coming. They know that “too big to fail” policies will never be able to hold up global financial markets when the economic and financial fundamentals come to play. They actually know that the market will fall, and some companies will disappear forever.

The problem is: they don’t know when this will happen and in the mean time they just can’t help themselves!

Absent interest rate returns, and in the presence of a roaring stock market, they can’t keep their eyes off it. The fear of missing out is just too strong, with some stocks jumping double-digits on a weekly basis! So instead of exiting the market, they jump right back in for one last go at it, before
promising to leave “at the end of the week” or even closer.

This attitude, at a large scale, is itself fueling the double-digit jumps. It is creating a self-fulfilling prophecy that the market will keep climbing, and that fear of missing out just increases and brings in more people who just realized they missed out on the last 40% jump, but they don’t want to miss out on the next one. This is a never-ending problem (a typical bubble), that will eventually lose steam and come down like a house of cards.

Possible answer: There aren’t any. The only question is, who will make it out before the house comes falling down, and who will not?

Remembering that those who come out, have tended to look back
and say: “the house didn’t come falling down YET, let’s go back inside for one last try”.

Conclusion:

Good advice, good data, and fundamentals are being thrown out the window because they are indeed irrelevant in the short-run.

If the market finds demand, it will go up. Regardless of fundamentals.

Are investors wrong for following a fundamentals-free rationale for investing? Not really.

Investors are doing what they have been taught to do: look for a (legal) way to maximize their gain.

This is exactly what they’re doing (if they get out in time).

Dr. Ahmed Badreldin is Assistant Lecturer at the Departments of Finance and Banking as well as Economics of the Middle East at the Philipps-Universität Marburg in Germany. Dr. Badreldin completed his Ph.D. in the field of Asset Pricing and Islamic Finance in 2018. In 2013, he was awarded a DAAD Scholarship to complete his second Master’s degree in Economic Change in the Arab Region from the University of Marburg. His fields of research are Islamic finance and asset pricing in mixed market settings as well as the economics of the Middle East with a focus on Shadow Economy and Monetary Policy. He has written extensively in several publications such as the International Journal of Islamic Finance as well as a co-authored chapter in a recently published book on Islamic Banking and Financial Crisis.

Disclaimer: this article is not meant as investment advice. Make sure you do your own due diligence before making any investment decisions. Never invest money you can’t afford to lose.