{"id":58683,"date":"2025-08-10T23:27:06","date_gmt":"2025-08-10T23:27:06","guid":{"rendered":"https:\/\/www.newsbeep.com\/au\/58683\/"},"modified":"2025-08-10T23:27:06","modified_gmt":"2025-08-10T23:27:06","slug":"does-the-stock-market-know-something-we-dont","status":"publish","type":"post","link":"https:\/\/www.newsbeep.com\/au\/58683\/","title":{"rendered":"Does the Stock Market Know Something We Don\u2019t?"},"content":{"rendered":"

This article was featured in the One Story to Read Today newsletter. Sign up for it here.<\/a><\/p>\n

Can anything stop the stock market? The U.S. economy recently weathered the worst pandemic in 100 years, the worst inflation in 40 years, and the highest interest rates in 20 years. Yet from 2019 through 2024, the S&P 500 grew by an average of nearly 20 percent a year, about double its historical average rate. Despite President Donald Trump\u2019s erratic economic policies, which include the highest tariffs since the 19th century, the market is already up by about 8 percent in 2025.<\/p>\n

As the stock market soars ever higher, the theories of why it rises have suffered the opposite fate. One by one, every favored explanation of what could be going on has been undermined by world events. The uncomfortable fact about the historic stock-market run is that no one really knows why it\u2019s happening\u2014or what could bring it to an end.<\/p>\n

According to textbook economics, the stock market\u2019s value reflects what are known as \u201cfundamentals.\u201d An individual company\u2019s current stock price is derived from that firm\u2019s future-earnings potential, and is thus rooted in hard indicators such as profits and market share. The value of the market as a whole, in turn, tends to rise and fall with the state of the broader economy. According to the fundamentals theory, the market can experience the occasional speculative bubble, but reality will bite soon enough. Investors will inevitably realize that their stocks are overvalued and respond by selling them, lowering prices back to a level that tracks more closely with the value justified by their fundamentals\u2014hence the term market correction.<\/p>\n

The fundamentals story held up well until the 2008 financial crisis. Within six months of the U.S. banking system\u2019s collapse, the market fell by 46 percent. In response, the Federal Reserve cut interest rates to almost zero and pushed money back into the economy by purchasing trillions of dollars in securities from financial institutions.<\/p>\n

The Fed\u2019s goal was to get the economy going again quickly. This didn\u2019t happen. For most of the 2010s, corporate earnings were modest, GDP and productivity growth were low, and the labor market remained weaker than it had been before the crisis. In other words, the fundamentals were not great. Yet the stock market soared. From 2010 to 2019, it tripled in value.<\/p>\n

Rog\u00e9 Karma: The Federal Reserve\u2019s little secret<\/a><\/p>\n

This gave rise to what became known as the \u201cliquidity\u201d theory of the market. In this telling, the force driving the ups and downs of markets was the Federal Reserve. As long as the central bank was willing to keep flooding the financial system with cash, that money would eventually find its way into the stock market, causing valuations to rise regardless of what was happening in the real economy.<\/p>\n

The apotheosis of the liquidity theory came in early 2020: The stock market crashed when the coronavirus pandemic hit, and the Fed once again responded by turning on the money taps. By mid-summer, unemployment was still above 10 percent, but the stock market had already rebounded past its pre-pandemic peak.<\/p>\n

But the liquidity theory\u2019s run was short-lived. In 2022, as inflation replaced unemployment as the economy\u2019s biggest problem, the central bank reversed course, quickly raising interest rates and selling its securities. As the liquidity theory would predict, the stock market took a nosedive, falling<\/a> by close to 20 percent. Then something strange happened. The Fed continued to raise interest rates over the course of 2023, to their highest levels in two decades, and kept them there in 2024. It also drained about $2 trillion<\/a> of liquidity from the financial system. Yet the market took off once again. The S&P 500 rose<\/a> by nearly 25 percent in both 2023 and 2024, making it the market\u2019s best two-year run of the 21st century. \u201cBetween 2008 and 2022, the view on Wall Street was we were experiencing a liquidity-driven market,\u201d Mohamed El-Erian, an economist and the former CEO of the asset-management firm PIMCO, told me. \u201cThat wasn\u2019t at all the case in \u201923 and \u201924.\u201d<\/p>\n

The stock market\u2019s performance in those years was unusual for another reason. More than half of the S&P 500\u2019s total growth in 2023 and 2024 was driven by the so-called Magnificent Seven<\/a> companies: Apple, Amazon, Alphabet, Meta, Microsoft, Tesla, and Nvidia. During those two years alone, Tesla\u2019s value rose by 286 percent, Meta\u2019s by 355 percent, and Nvidia\u2019s by 861 percent. The biggest firms have always been responsible for a disproportionate share of the market\u2019s growth, but never had the gains been so acutely concentrated. The phenomenon couldn\u2019t be explained solely by superior business performance; the Magnificent Seven\u2019s stock prices had begun to exceed<\/a> earnings by record amounts, implying that their valuations had more to do with expectations about future growth.<\/p>\n

This gave rise to a new theory: The stock market was being supercharged by the coming AI revolution\u2014or, at least, by belief in it. The Magnificent Seven\u2019s extreme surge began in early 2023, shortly after the release of ChatGPT, which kicked off a wave of interest and investment in the AI sector. The seven companies seem especially well positioned to prosper from the emerging technology, either because they provide crucial inputs to the development of AI models (Nvidia), are investing heavily in building their own models (Meta, Microsoft, Alphabet), or stand to benefit significantly from automation (Amazon, Tesla, Apple).<\/p>\n

To some experts, the situation has all the markings of a speculative bubble. In a recent blog post<\/a>, Torsten Sl\u00f8k, the chief economist at the asset-management firm Apollo, pointed out that the top 10 companies in the S&P 500 today are more overvalued\u2014meaning their stock prices exceed their earnings by larger factors\u2014than the top 10 companies at the height of the 1990s dot-com bubble were.<\/p>\n

Take Nvidia, the chipmaker that recently became the first company in history to hit a $4 trillion valuation. Historically, the average price-to-earnings ratio for a company in the U.S. market has been about 18 to 1, which means that to buy a share of stock, investors are willing to pay $18 for every $1 of the company\u2019s yearly earnings. Nvidia\u2019s current price-to-earnings ratio is 57 to 1.<\/p>\n

AI boosters argue that these valuations are justified by the technology\u2019s transformative potential; skeptics respond that the technology is far from being adopted at scale and, even if it eventually is, that there\u2019s no guarantee that these seven specific companies will be the ones to rake in the profits. \u201cWe\u2019ve seen this story play out before,\u201d Jim Bianco, an investment analyst, told me, pointing to the dot-com crash of the early 2000s. \u201cJust because there\u2019s a truly revolutionary technology doesn\u2019t mean stocks are correctly pricing in that reality.\u201d<\/p>\n

If the current market froth is indeed an AI bubble, then a day must come when the bubble bursts. For a moment, that day appeared to have arrived on April 2, when Trump announced his \u201cLiberation Day\u201d tariffs. Over the next week, the stock market fell by 12 percent, and the Magnificent Seven took even steeper hits.<\/p>\n

But then, on April 9, Trump backed down from his most extreme tariff proposals and, a few weeks after that, de-escalated what seemed like an imminent trade war with China. The market swiftly recovered and launched into a bonanza even wilder than those of the previous two years. The S&P 500 has risen nearly 30 percent since its post\u2013Liberation Day low, setting all-time records, and the Magnificent Seven have come roaring back. This gave rise to the concept<\/a> of the \u201cTACO trade,\u201d as in \u201cTrump always chickens out.\u201d The idea is that Trump hates falling stock prices and will back off from any proposal that puts the market in jeopardy. So rather than sell their stocks every time the president threatens to impose crippling trade restrictions, investors should continue to pour money into the market, confident that the proposals Trump ultimately leaves in place won\u2019t do much damage.<\/p>\n

The flaw in the TACO theory is that Trump hasn\u2019t completely chickened out. Tariffs are the highest they\u2019ve been in more than a century, and the president is announcing new ones all the time. Still, the market appears largely unfazed. When Trump announced \u201ctrade deals\u201d with the European Union and Japan that set the tariff on most goods arriving from those places at 15 percent, the stock market actually rose. Even last week, when the president announced a sweeping new set of global tariffs\u2014an announcement immediately followed by a brutal jobs report<\/a> suggesting that tariffs were weakening the economy\u2014the market suffered only a blip. As of this writing, it is higher than it was before the announcement.<\/p>\n

This leaves a final theory, one that has nothing to do with Trump, AI, or the Federal Reserve.<\/p>\n

Thirty years ago, almost all of the money in the U.S. mutual-fund market was actively managed. Retirees or pension funds handed over their savings to brokers who invested that money in specific stocks, trying to beat the market on behalf of their clients. But thanks to a series of regulatory changes in the late 2000s and early 2010s, about half<\/a> of fund assets are now held in \u201cpassive funds.\u201d Most retirees hand their savings over to companies such as Vanguard and Fidelity, which automatically invest the money in a predetermined bundle of stocks for much lower fees than active managers would charge. The most common type of passive fund purchases a tiny share of every single stock in an index, such as the S&P 500, proportional to its size.<\/p>\n

Annie Lowrey: Could index funds be \u201cworse than Marxism\u201d?<\/a><\/p>\n

Some experts believe that this shift is the best explanation for the otherwise inexplicably resilient performance of the stock market. \u201cThe move to passive funds is a radical shift in the structure of financial markets,\u201d Mike Green, the chief strategist at Simplify Asset Management, told me. \u201cTo think that wouldn\u2019t dramatically impact how those markets behave is just silly.\u201d<\/p>\n

Active investors are highly sensitive to company fundamentals and broader economic conditions. They pore over earnings reports, scrutinize company finances, and analyze market trends, and will often sell at the first sign of an economic downturn or poor company performance, which causes markets to \u201ccorrect.\u201d Passive investors, on the other hand, typically just pick a fund or two when they set up their retirement accounts and then forget about them, meaning they are automatically buying stocks (and rarely selling), no matter what. In June 2020, for example, Vanguard released a statement<\/a> bragging that fewer than 1 percent of its 401(k) clients had tried to sell any of their equities from January to the end of April, even as the economy was melting down.<\/p>\n

Thus, whereas a market dominated by active investors tends to be characterized by \u201cmean reversion\u201d\u2014in which high valuations are followed by a correction\u2014a market dominated by passive investors is instead characterized by \u201cmean expansion,\u201d in which high valuations are followed by even higher valuations. \u201cWhen there\u2019s a constant flow of passive money coming in, betting against the market is like standing in front of a steamroller,\u201d Green said. \u201cYou\u2019d be crazy to do it.\u201d<\/p>\n

A market dominated by passive investors also naturally becomes<\/a> more concentrated. Active investors tend to avoid larger stocks that they believe might be overvalued, but the opposite is true for passive investors. Because they allocate funds based on the existing size of companies, they end up buying a disproportionate share of the biggest stocks, causing the value of those stocks to rise even more, and so on.<\/p>\n

The explosion of passive funds over the past 15 years could explain why the market has become less sensitive to real-world downturns, more likely to keep going up no matter what, and dominated by a handful of giant companies. Or that theory could end up being disproved by unforeseen events. It wouldn\u2019t be the first.<\/p>\n","protected":false},"excerpt":{"rendered":"This article was featured in the One Story to Read Today newsletter. Sign up for it here. Can…\n","protected":false},"author":2,"featured_media":58684,"comment_status":"","ping_status":"","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[12],"tags":[64,63,99,171],"class_list":{"0":"post-58683","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-markets","8":"tag-au","9":"tag-australia","10":"tag-business","11":"tag-markets"},"_links":{"self":[{"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/posts\/58683","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/comments?post=58683"}],"version-history":[{"count":0,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/posts\/58683\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/media\/58684"}],"wp:attachment":[{"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/media?parent=58683"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/categories?post=58683"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.newsbeep.com\/au\/wp-json\/wp\/v2\/tags?post=58683"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}