TL;DR in two equations:
Assume $5 per share is fair value. Observe that $100 * (1 – 0.99) = $1 is a 99% fall, and $1 * (1 + 4) = $5 is a 400% rise.
Feel free to skip the rest of the post if the point it clear.
Suppose there's an overleveraged, highly cyclical, poorly managed company called WayUnfair. It's true value is $5 a share according to some omnipotent being that happens to know the precise future stream of cashflows and path of interest rates.
The company, due to meme-mania and uninformed analyst reports, trades at $100 a share last week, or 20 times its fair value. The market suddenly gets spooked and the company's shares fall 99% in value, to $1 a share, as $100 * (1 – 0.99) = $1. The company is now worth a fifth of its true value.
Eventually the economy/stock market doesn't seem so scary. The company zooms up some 70%, and people on Twitter and Reddit are like, “This is absurd, Fed needs to raise rates by 100 basis points.”
In reality, the company is now worth $1 * (1 + 0.7) = $1.7 per share. The fair value is still $5 per share, so the company is trading at 37% of its fair value. The company's share price would have to just over triple in order to reach fair value, even after a 70% rise. In fact, after its 99% fall, it now needs 400% to reach fair value.
Obviously fair value is not known to us all, and perhaps WaiUnfair, Tsarvana, Nico-cacola are still overvalued. But if these horrible companies fell some 80, 90, 99%, rising back some 20 or 30% means very little. Unless they are proceeding to rise 500% or something, we are not already back at the frothy valuations of a year or two ago.
Percentage changes are terrible ways to assess change when the base price we are applying changes to are dramatically different. If you're concluding the market has gone wild just because you are seeing the shittiest stocks rise 70%, you could be being mislead.
Moreover, at the start of any rally, justified or not, the worst quality junk stocks that have traded down the most will always rise the most. The giants like MSFT or UNP which traded down some measly 20 or 30% are not going to rise as much as those high-beta, quasi-fraudulent companies that fell 88%.
Why am I making this post? People on Twitter and Reddit are making the rounds highlighting these eye-popping rallies in low quality meme-stocks as a sign of a stock market back at 2020 craziness. This is insufficient proof alone.
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