The illusion of stock market prosperity

The ups and downs of the stock market is reported daily, hourly – continuously on some news channels. Stock markets are seen as indicators of the overall economy. A rising stock market means prosperity, and a falling stock market spells bad news. But is the stock market actually a good proxy for the health of the economy?

Stock markets of course only include a subset of companies in the country, and so already we are assuming the health of the largest companies is equivalent to the state of the overall economy. The FTSE 100 is quite obvious. The Dow Jones in the US only has 30 companies listed – perhaps a surprise for such a closely monitored index. For now, let’s assume that by using a variety of indices (eg NASDAQ, S&P 500 in the US) we can get a decent enough proxy in terms of the companies that are listed.

Prices act as signals of supply and demand – one reason why we should always be hesitant to control them. Prices provide information – information that you could not get easily otherwise. You may not know that bad weather has reduced the supply of oranges in Spain, but you can see that oranges have gone up in price and so you’ll buy less – reducing the pressure on the reduced supply.

In a similar way, stock prices reflect the supply and demand for shares in a particular company. Unfortunately the demand for shares is often artificially boosted by cheap money provided by central banks, and prices rise more than would be expected by the fundamentals. While inflation is supposedly under control according to the CPI, inflation in assets such as stocks and real estate is much higher. The cheap money from central banks is not going into consumers pockets, and hence CPI is not rising so much. Instead, the cheap money is lower borrowing costs for property buyers and stock market investors alike, and hence the inflation can be seen in these markets instead. If all assets were included in the inflation index, we’d see a very different picture.

Such a scenario is what took place during the 1920s, and hence what has led so many economists to reject the notion that the  crash of 1929 was caused by an inflationary boom. Where’s the inflation they ask? CPI was stable, if not falling during the 20s. Same as now, there was significant inflation in stock prices and real estate – at a time when the Federal Reserve was increasing the money supply. The new money ends up somewhere – its just that the official statistics are good at hiding it. When we look at the broader economic picture, the bubbles blown by the new money become much clearer.

So far, all very theoretical. Yet evidence for this distortion can currently be seen in the US and the UK . In both countries, stock markets are reaching new highs (beating the high prior to the financial crisis) while unemployment remains stubbornly above rates seen before the crash. There is a clear disparity between the two. Even more starkly, in Venezuela, the stock market is rising rapidly amid soaring inflation, while there are shortages of toilet paper and the government continues its attempt to defy reality by imposing price controls and seizing businesses. The rising stock market is completely detached from the real nature of the economy.

This certainly benefits anyone holding stocks, but it’s not helping anyone else. It’s another way that central banks are helping the rich at the expense of the poor. Some may believe a rising stock market brings confidence, and economic prospects will improve as a result. However, if the stock market is only reflecting the influx of cheap money rather than the reality of the economy, it fails to be a signal and instead becomes meaningless. Blowing a stock bubble will only end one way. Central banks would do well to heed the lessons of the past, and stop blowing new bubbles in order to save us from the last one that burst.

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1 Response to The illusion of stock market prosperity

  1. David says:

    Very good article

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