Whenever the stock market has a good run the mainstream media always cite it as evidence that Obamanomics is actually working, the $16 trillion national debt isn’t all that bad, and that Keynesian economics really makes sense. When it declines, they refer to it as a readjustment, or a response to the European crisis or some other elusive, non-controllable event. The stock market is an interesting economic indicator, but not always a reliable reflector of economic growth. While I’m not disseminating any investment advice, here are a few things to keep in mind when watching moves in the market:
1. The DJIA does not always correlate with economic progress. In fact, the last three decades is replete with stock market increases during bad economies and drops during economic expansions. Over the long term, the stock market is a reliable indicator of economic activity, but you have to look at years of data to make sense of this.
2. Stock prices are a function of supply and demand, especially over the short run. The more people invest in the market–regardless of the reason–the higher prices will go. This is why stock prices decline when there is global uncertainty, with many investors moving funds to cash or gold, lowering demand for stocks and thereby triggering an overall decline. This is also part of the reason why the Fed keeps interest rates artificially low. By guaranteeing that ordinary investors cannot receive a reasonable rate of return for cash deposits in savings accounts and CDs, the Fed pushes average investors into stocks. Ask yourself, how much money would leave the market immediately if returns on one-year certificates of deposit rose to 5%? Enough to send the Dow into a tailspin.
3. Few individual or institutional investors purchase a stock at a certain price because they believe a company’s future earnings justify that price. Instead, they purchase a stock because they think the price will rise, even if the increase is irrational. I can’t tell you the number of investors I’ve spoken with over the last few years who are convinced that fiscal problems will drive the U.S. economy to ruin but are still heavily invested in the stock market. Their reasoning is simple. They believe the day of reckoning is still a few years away. With cash returns in the 1% rate–below inflation–they are hoping to ride the market for a while longer and dump their holdings when the next financial crisis hits. Investors call this the greater fool theory because it assumes that a fool is always waiting around the corner to pay more for your shares of a given stock that you did. Keynes referred to this phenomenon as the beauty contest principle of investing because investors are often less concerned with what a stock is really worth and more concerned with what they think others think it is worth.
Most left-leaning pundits ignore these realities because they don’t fit in the pro-Obama narrative. They seek to use the stock market’s rise or fall to reinforce their claims that an expanding, far-reaching and intrusive government is actually good for business and economic growth. Sometimes market moves can be largely attributed to simple drivers, but more times than not they can’t.
BTW, you might be surprised that I cited Keynes favorably in this post. Keynes offered a number of sage observations about the economy and we should be willing to consider each on its own merits. Even Paul Krugman is right once in a while, although such instances are not very common these days. Arguments from Keynes, Krugman, and other misguided economists typically open with a few legitimate insights before drifting astray. There’s nothing wrong with giving each of them a fair hearing. It’s a shame that those on the left won’t give Hayek, Mises, and Hazlitt the same consideration.