Yet if market activity in early 2021 is any indication, people still equate speculation with investing.

Who can blame them when confused contradictions exist? Stock prices are hitting new highs as an economy affected by the pandemic continues to struggle. Shares of failing companies explode higher as retail investors organize on social media and pile up. And new inflationary fears are emerging despite the abundance of labor and industrial capacity.

Are the gaps between perception and reality widening? Is the investment risk increasing or do we just have too much free time?

Stock prices and economics

The link between the economy and the capital markets is loose. The shares broadly reflect the outlook for growth, not what is happening now. The real challenge is to arbitrate the gap between perception and reality. Time explains much of the difference.

For example, one could reasonably predict that after the pandemic things will return to normal and pent-up demand for restricted services, like restaurants and travel, could create an economic surge.

The reality may be different. The rebound percentages from a depressed 2020 will seem more impressive than they are – 50% drops need 100% gains to get revenge. Consumer confidence, rehire and recovery will be tempered by uncertainty about the nature of the rebound. Remote working will change the way some businesses choose to operate in the future. Rerouting supply chains may take longer than expected. Some consumer behaviors, such as shopping in malls, may never return to pre-pandemic levels.

How will the stock markets react if the economic rebound does not measure up?

GameStop and uncertain company valuations

The perception-reality gap was fully visible in the stock markets at the start of this year. Shares of video game retailer GameStop rose from $ 20 to $ 467 (in US dollars) thanks to speculation sparked by the WallStreetBets forum on Reddit and traders using commission-free online brokerage firm Robinhood. GameStop action then fell to around $ 45 before rebounding at the end of February.

Robinhood’s 13 million accounts were encouraged to participate in the exchange (many on margin) as everyone was locked out due to Covid-19. Many traders were relative newbies – the platform added more than 3 million accounts in 2020. Robinhood’s median account holder is 31 years old, with less than $ 5,000 in their account (up from six figures in companies such as Fidelity and Schwab). Buying the big bottom of March 2020 meant everyone was making money early. The success emboldened new players.

Meanwhile, short sellers drawn to the “Video Game Blockbuster” were betting GameStop would join major retailers that filed for bankruptcy in 2020.

The reality of the business is that new board members can turn GameStop into an online business, albeit against all odds. The reality of the short-term market is that the populists on Reddit were able to inflict significant losses on hedge funds with their short squeeze. The longer-term reality is that corporate fundamentals need to shift to support seemingly high valuations.

Even if they lost, retail traders will have learned a valuable lesson: Speculation is different from investing, and stocks can go down too.

Inflation

Rising inflation is the biggest risk for capital markets today. The current bull market is based on low inflation and falling interest rates. Yields on 30-year US Treasury bonds fell from 1% in March 2020 to 2% in February 2021. If they double again to 4%, the perceived value of future earnings will need to be adjusted upward and multiples P / E down, making stocks vulnerable.

Determining how much inflation will affect other sectors in the coming periods is key to market movement. But if you remember when inflation was in double digits and how the psychology of rising prices impacted economic prices, you’re either retired or thinking about it.

A whole generation of investment professionals are on the prowl for something they have never experienced personally. The perception is that inflation is not rising, held in check by secular demographic and technological trends. The reality could be very different.

A real risk is not to understand the dynamic between reality and the perception of the impact of inflation. Will it be an educational moment at the GameStop? Time will tell us.