This is why stocks sometimes respond badly to upbeat economic news
The key to the ‘good is bad’ puzzle lies in how present values are determined
Why do risky assets such as stocks sometimes respond poorly to good economic news? It feels intuitively wrong. After all, any indications that the global economy is recovering suggests the pace of earnings growth will start to accelerate. Higher equity earnings growth normally means higher valuations because the price of an equity is simply the present value of all its future earnings.
The key to the “good is bad” puzzle lies in how present values are determined. It’s not just about earnings but also about the rate at which those earnings are discounted back to the present. The higher the discount (or risk-free) rate, the lower the present value of the earnings stream. It’s entirely possible, therefore, to have higher earnings but a lower valuation, if the discount (or risk-free) rate is sufficiently increased...
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