Excessive unproductive liquidity causes irrational speculation in stock markets

(July 17): This market rally is, without a doubt, driven by massive amounts of liquidity, created by major central banks of the world in an effort to limit the fallout from the Covid-19 pandemic. To many, the strong global stock market recovery from the lows in March and subsequent resilience appear disconnected from the dismal economic data and corporate earnings. After all, the price of a stock is supposed to reflect its underlying intrinsic value, which is the discounted future cashflow stream, plus a layer of premium for risks and liquidity. By this measure, many of the best-performing stocks are trading at irrational valuations.

The reality is that, while earnings and cash flow determine stock prices in the long run, short-term prices are driven by demand and supply. Investor demand is, in turn, driven by prevailing storylines.