Markets misconception: Markets always corrects to normal

“Wall of Ignorance or Bridge of Understanding,
We can’t choose what others build for themselves,
But we can choose what we spend our time on. “

There have been a few misconceptions about the financial markets which has been bothering us. Things we tend to pick up because it is our favorite subject. The answers are always surprisingly complex and multifaceted.

Misconception #1: Markets always corrects back to normal
There are many variations of this. P/E ratio is very high now, overvalued and must fall.
Rental yield is so low now, correction is coming.

Answer:
One thing is, many people still see the stock market as a gambling instrument. It is not a place for people to make informed funding of businesses and to earn cashflow from the profits. As in gambling, there are winners and losers, so when something goes up, it must come down.

Another thing is that people believe there is such thing as a long term average. Interest rates has been 3% for such a long time so it must be true. Rental yield has been 5% for such a long time so it must be true. P/E ratio 13 is average. Buy below this line, sell above this line.

The truth is that the so called ‘corrections’ comes when people shorten their investment horizon or lengthen it.
When crisis hit, we cannot look past tomorrow, hence businesses are priced as if they are closing tomorrow. Properties are priced as if they are on fire sale.
When confidence starts increasing, businesses are first priced for a 5yr income period, then 10yr, then 20yr, up till forever. Properties are priced to assume 5yr gains potential, then 10yr, then 20yr, up till forever.

What also is the meaning of ‘average’ and ‘normal’. Why is 3% the interest rate? Why is 3% the price of money? Why is 3% the value of inflation? What decides it?
So ok, supply and demand decides it.
Supply side we have government printing money. We have more and more savings looking for investment.
Demand side we have more and more population and people being born. We have technology and competition driving down prices.

These are the complex interactions which produce the interest rate, the inflation rate, the return on investment at this time. And the past won’t be the future.

Quite a few people look at charts religiously, assuming in their point of view what is ‘average’ and what is ‘normal’. And a few others are quick to assume conspiracies when ‘average’ and ‘normal’ doesn’t happen. There’s no need to assume conspiracies, the complex interactions of confidence and fear is already enough to produce a variety of outcomes. And if we can maintain a clear picture of all variables, we can easily see the long term trends.

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