If you were forced to make a choice, would you describe the stock market as the driving force of the economy, or rather as a casino?
“I think I’d pick the former. I think the stock market – like the entire financial system, including banks – plays an important role in financing economic activity. Companies can raise money, use it to invest, then grow. But of course, there’s a different side to it, as well. Once the funds have been raised, the investors will start trading those shares among each other. And the value of the shares generally doesn’t have immediate consequences for the company, except for things such as the executives’ remuneration.
“The comparison with a casino is apt in a way, because the stock market is unpredictable, just like a casino. So you could say it’s just speculation. But the ironic thing is that this unpredictability is also a sign that the stock market is actually working very well. The value of a share is determined by the company’s current profitability, the amount of dividend promised and long-term expectations. The long term is uncertain, but updates are released quite regularly. Which is unpredictable by definition.”
You seem to be implying that there is a relation between the value of a share and the value of a company.
“There most definitely is. It’s not a perfect relationship and there are definitely moments where things seem quite unaligned. But the stock market isn’t completely detached from reality, as some people will tell you.”
One of the companies critics say is being hugely overvalued is Tesla. It’s a promising company and Elon Musk is doing revolutionary stuff. But is a share price increase from 30 to 800 dollars within a year justified?
“Tesla is a trendsetter and has done brilliantly in the past few years, but I have some misgivings about its share price. We know that people are sensitive to great stories and apt to lose sight of reality on occasion. The best example of this is the dot-com bubble of the late 1990s. Tesla doesn’t sell that many cars or make huge profits. And just about any car brand has by now begun producing electric cars. The current share price only seems justifiable if they will continue to be dominant in the market for many years (just after this interview, Tesla’s share price plummeted and the company’s trade value was reduced by more than 300 billion – ed.).”
The IMF has issued a warning, saying that we’re facing a split reality. To what extent are we witnessing the birth of an economic bubble?
“It’s very hard to say for sure. In principle, the value of a share represents all the dividend that will be paid out in future. That future might just last a few hundred years, so it’s very hard to include this in the share price. But it’s obviously very strange that the stock markets are doing better than ever even though the economy has just had a disastrous year. I would not advise people to start investing now.”
We could go short, right?
“History teaches us that all things that go up spectacularly must come down at some point. You can place bets on the fall of a share price. However, the question is whether you can time it. I’ve been conducting research on stock markets for twenty years, but I don’t actually buy shares. The tulip bulb bubble of the seventeenth century, which saw certain types of tulip bulbs sold for amounts that could buy you a nice house on a canal, lasted a few years, as well. Going short can end up costing you an absolute fortune if share prices keep rising for a while.”
How is it possible that stock markets are doing so well even though the economy has taken an absolute hammering?
“There are several causes. First of all, many companies are receiving government support, because it’s very cheap for governments to borrow money. As a result, the blow isn’t nearly as tough. We learned in the previous financial crisis that this is a genuinely good idea. In addition, we expect that, once the economy opens up again, demand will be tremendous, just to make up for the lockdown. Furthermore, people have spent a lot less in the last year, which has resulted in a huge investment boom, particularly among private citizens. This is in line with a global trend whereby people are saving a lot of money, the so-called savings glut. We’re talking about an enormous amount of money. We did see share prices fall in March of last year – they lost about one-third of their value – but in the end, that money must be spent in some way or another.”
There is a lot of money around. Is that creating a dangerous situation?
“It is if it results in economic bubbles. But alternatively, it may well reduce the returns. Suppose you’re considering buying a share that you expect to be worth one hundred euros next year. So if you’re after a 5 per cent return, you’re willing to pay 95 euros for that share. If you’re willing to make do with a 2 per cent return, you’ll be willing to pay as much as 98 euros. Back in the day, a share yield of 10 per cent per year was realistic. With the current share prices, that number is completely unrealistic. In the long term, you won’t get more than 3 to 4 per cent, if that.”
Thanks to apps such as Robinhood and Degiro, it has become cheap and easy to trade in shares. The number of households in the Netherlands with share portfolios rose by 17 per cent to 1.75 million in 2020. In recent months, a large number of private investors has immensely driven up the price of GameStop shares (among other shares), and in so doing caused several large hedge funds to lose billions of dollars. To what extent is there a revolution going on in the stock market, with ordinary people grabbing power from institutional investors?
“They have already been compared with Occupy Wall Street. We’re seeing the democratisation of the financial markets. Financial institutions don’t have a great reputation, which is partly their own fault. I think it’s nice that ordinary people are getting a bit more of a say again, and I’m curious to see what happens next. But I’m worried about it, as well. Many people have begun investing because they read all the stories about others who made a lot of money in a short period of time, by buying and selling Tesla or GameStop shares at the right time. Or by starting investing in March – I wish I’d done that – and doubling their stake. But there’s a great deal of research out there that has taught us that next to no one is capable of beating the stock market systematically. For every person who earns a million, there is another person who loses a million. And I’m wondering if people are currently getting that message.”
Actions such as the GameStop action result in highly volatile share prices and general instability in the stock market. Is that a bad thing?
“The major blows will be borne by people who start investing at a time when share prices are really high and then plummet. Major institutional investors such as pension funds aren’t that active, so they will see through these fluctuations. If these weird practices become common practice, there may be another consequence: companies and investors may lose their faith in the stock market. This may then cause companies to turn to private equity when they need capital, which might not be a desirable situation. Generally, the stock market plays its part very efficiently, and, moreover, it forces companies to be transparent about all sorts of things.”
If there is an awful lot of money around, it makes sense that money loses some of its value. However, we’re not seeing a great deal of inflation. To what extent are we dealing with hidden inflation? For instance, due to the ever-rising house prices?
“I’m not a monetary economist. But it’s not inconceivable that the ECB’s lowering of interest rates contributed to the rising prices on, say, the stock market or the real estate market. I’m not a great fan of that generous policy. If you try to keep interest rates low for that long, things will get skewed along the way.”
Let’s get some investment tips to finish this off. So you didn’t start investing when the stock market crashed in March 2020, did you?
“No, I didn’t, and I kind of regret that. I know several people who did do it and they ended up with a tidy profit. The same thing happened in 2008. I once told myself that the next time it happened, I’d be right there. And yet it’s tricky. You never know what’s going to happen when the market crashes like that. Things may get even worse. That’s why I’m careful, both in my answers and in my investments. For now I’m drawing the following conclusion: I’m leaving it in my bank account, even though we currently have a negative interest rate.”
Mathijs van Dijk is a Professor of Finance at the Rotterdam School of Management. He conducts research on stock markets, sustainable investments and financial crises.