Professor’s opinion: Why have stock markets suddenly crashed?

Risk assessment

Let’s return to the current situation. How can we make sense of this 33 per cent drop in share prices? We see that a lot of companies have been hit by the COVID-19 crisis and the low oil prices. The profitability of airlines has been seriously undermined, affecting their ability to pay dividend to their shareholders. But for a 33 per cent decrease in share prices to be explained by decreased profits only, the expected profitability of all listed companies should permanently have decreased by around one third. This hardly seems likely.

Apart from a decrease in expected dividends (due to lower returns), however, the theory also proposes another explanation for the fall in share prices: an increase in investors’ RRR – and thus the discount rate. An increase like this is determined by two factors: investors’ assessment of the risk posed by a share, and their level of ‘risk aversion’.

The latter two factors are known to increase in times like these. Investors can reasonably expect companies’ share value to be more uncertain than a few weeks ago. We simply don’t know yet how much corporate profits will be affected by the present crisis. What’s more: investors are less prepared to take risks in times of crisis. Both factors lead them to seek a higher RRR, which also explains in part why share prices have plummeted to this degree.

Panic

So what about panic then? The conventional theory assumes that investors make purely rational decisions. There’s no room for panic or other psychological effects. The idea that share prices always precisely reflect a rationally established discounted value is known as the ‘efficient market hypothesis’. This hypothesis also says that future share prices are entirely impossible to predict. In other words, share prices evolve according to a ‘random walk’. This doesn’t mean the stock market itself is completely random. If share prices truly follow a random walk, this is actually the sign of a perfectly functioning market. The reason for this is that, in an efficient market, share prices only change in response to new information – as it comes in. And news is by its very nature unpredictable.

Over the past few decades, we’ve seen a lot of evidence that psychological factors do play a significant role on the stock market. Share prices can deviate from their actual, rational value for prolonged periods of time. But such irrational valuations can only be recognised in hindsight. Even professional investors aren’t able to systematically beat the market by taking advantage of market inefficiencies.

What does this mean for the stock market? Panic may indeed be playing a part in the current bear market – leading to new opportunities for bargain hunters. But there could also be a rational explanation for the recent drop in prices: lower expected profitability combined with a higher rate of return as required by investors. The fact that the market isn’t entirely governed by chance is obvious when we look at the current valuation of KLM shares, which has dropped at a far higher pace than Ahold, for example. But it is also possible that the market may still have been too cautious, with share prices falling even further in the period ahead.

If the current crisis proves relatively brief, with limited economic fallout, investors’ RRR will once again decrease (leading to a recovery in many share prices) as soon as the worst uncertainty has passed. But who knows whether and when this will be the case? That’s the irony of the efficient market hypothesis. We know that in many cases it is not a good description of stock markets, but that doesn’t make predicting the market any easier. But at the same time, that’s also what makes stock markets so interesting.