Why are stocks falling?

Author: Gagan

Because recession + inflation reduce profits while rising interest rates make stocks less valuable.

💵 Stock price of a company is the approximate value of a company’s future profits, adjusted to today’s dollar value. It’s usually adjusted for risk as compared to the least risky investment, the US government debt (aka treasury bonds or T-bills).

Which means, three things primarily drive stock prices*.

💰 Profit → Direct correlation. More profits a company makes, the higher its market cap will be.

📈 Profit Growth Rate → Direct correlation. Faster a company’s profits are likely to grow in the future, the higher the market cap will be today.

🇺🇲 Risk Free Rate → Inverse correlation. When risk free investment US government debt starts paying more interest, it reduce the allure of relatively riskier stocks, at least in the short term.

Over the last few months, things changed drastically:

📉 Lower Profits: Profit amounts and profit growth rates of the companies are starting to hurt from lower demand (recession) and higher inflation. Snap, Netflix, Facebook, Shopify, are some of the companies that revised their profit estimates lower recently.

📈 Risk Free Money: Risk free rate has been increasing steadily as the US Fed is raising rates rapidly from 0.25% to 3.25% to combat inflation. A 13x change in interest rates is bound to change the equation a decent bit.

🧠 During a panic selling period like right now, some really good stocks and sectors get crushed. Recessions offer great opportunities for investing for the long term. Great companies are selling at a discount right now.

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• For simplicity, I have stripped out many details that go into calculating the exact stock price for a company. If you would like to have a deeper discussion, feel free to reach out via LinkedIn or at Xillion Gagan 🚀🚀

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