Trends: Stock Market Returning to Fundamentals

Over the past two years, the stock market has continued to rise with intermittent dips. Why is that? A few reasons, but one of the highest is story stocks. Investors are buying a story rather than real valuations based on revenues. With the recent downturn in the markets, we can see that this kind of stock market buying frenzy is finally reaching an end.

No More Free Money

The age of free money is over. The Federal Reserve has raised interest rates at the fastest rate in 40 years. Frontline recently had a brilliant documentary on this very subject. After over a decade of the Fed propping up the stock market and asset prices with cheap money following the 2008 crisis, the pandemic completely upended the entire financial system. On top of that, the government then poured 5 trillion dollars into the economy on top of what the Fed was already doing with quantitative easing.

The reality is that the Fed needed to start raising interest rates in 2017 or 2018, and instead they kept interest rates low and kept buying various distressed assets. The policy has created what some call “the everything bubble” but most importantly, it has removed the signals from the market on what is valuable and what is not. Different types of debt and even whole companies should have failed and been written off by now, but they have not been due to Fed policy.

Now that the Fed is no longer propping up these companies and their bad debts, we are seeing the result. Tech layoffs are widespread, with tens of thousands of people getting laid off from nearly every major tech company except Apple. The changes in debt and rising interest rates have also caused a minor banking panic, as seen with the latest shut down of Silicon Valley Bank and the rescue of First Republic bank. The market correction that should have come years ago is finally arriving. The talking heads on CNBC are already complaining that the Fed “can’t keep going with interest rate hikes” even though that is what the economy needs to tamp down inflation and cause the market correction that is needed. There is simply too much money in the system.

As far as stock prices go, this means that the stocks will return to fundamentals. Rather than buying stocks on the “story” or on potential, it is time to return to a place where companies who can create real value get higher valuations rather than artificially raised valuations based on the ability to take on debt to buyback stock.

EBITA Matters

Value investing is considered old-fashioned. Some would even say that value investing leaves money on the table. Value investing is simple: companies who make a product or provide a service and make money doing that over time (and that is the key, over time) are the best companies to invest money into for the future. This is the fundamental investing thesis of Warren Buffett. He buys into companies that make a real product or provide a real service, and then he hangs onto them for long periods of time to see a return on the investment based on the real, created value.

We are moving into a phase where the best strategy for stocks will be investing for real underlying value. Any company worth investing in needs to be creating real value and generating a return on that basis. For the last two years, the entire market has been distorted by cheap money and investing that has no basis in reality. In 2022, this all came crashing down, and it is time to return to a value investing thesis. It will be good for the market and good for stock portfolios.

Main Street v. Wall Street

The fact that main street is being hit by inflation is hitting Wall Street, and that’s the way it should be. Gas, food, and other regular expenses are eating up the discretionary income of regular people. We’ve seen this recently in several missed earnings reports from Target, Amazon, and Walmart.

Although things have modestly improved in 2023, the consumer is being squeezed and this means that with less disposable income running around, people will be pulling back on spending. This will send stocks lower. This is a good thing. This is part of the normal function of markets. The question is whether the Fed will let the market function in a normal fashion or will continue to prop things up.

Personally, I hope that the Fed stays brave and keeps interest rates up and lets the market clean out the garbage that has crept up due to loose fiscal policies. Ultimately, the Fed is trying to address a problem that should have been addressed 5–6 years ago. The stock market needs to return to fundamentals, and that will be good for the economy over the long term. It will be good for main street as well because prices will have to come down to meet the consumer demand and that will bring an opportunity for actual growth from productivity rather than financial games.