Where does the stock market and economy meet?

The Hutch Report

This idea of buying and selling stock in a company was originated by the Dutch in 1602. As the practice spread to other countries the volume of shares increased.  At this point the need for an organized marketplace to exchange these shares became necessary. The modern concept of a stock market took hold in England where traders would meet at a London coffeehouse.  In 1773, the traders took over the coffee house and changed its name to the “stock exchange.” The first exchange, the London Stock Exchange, was thereby founded. The idea made its way to the American colonies with an exchange started in Philadelphia in 1790 and eventually the New York Stock Exchange in 1817. 

The term Stock is used to symbolize an investor’s ownership in a company. Upon purchase of the stock the investor theoretically owns a percentage of everything the company owns or owes. The company’s profitability, or lack thereof, determines whether its stock is traded at a higher or lower price. The practice began as many pioneer merchants wanted to start huge businesses. This required substantial amounts of capital. It was an amount of capital that no single merchant could raise alone. Therefore, groups of investors pooled their savings and became business partners and co-owners with individual shares in their businesses to form joint-stock companies.

Psychological effects

The US economy’s GDP is primarily driven by spending (70%) and investment (18%). The stock market affects gross domestic product primarily by influencing financial conditions and consumer confidence. This confidence spills over into increased spending, which can lead to major purchases, such as homes and automobiles and thereby increase the GDP.  So, when the value of stocks are increasing there tends to be a great deal of optimism surrounding the economy and the prospects of various stocks. In comparison, when the value of stocks are falling, it can have a negative effect on sentiment at which point investors rush to sell stocks to prevent losses on their investments. Those losses typically lead to a pullback in consumer spending, especially if there’s also the fear of a recession (two quarters of negative growth). When GDP rises, corporate earnings increase, which makes it bullish for stocks. The inverse occurs when GDP falls, leading to less spending by businesses and consumers, which drives the markets lower. At least that is the theory. 

Todays reality

Looking at the extraordinary events of today, the stock market looks increasingly divorced from economic reality. The United States is on the brink of the worst economic collapse since the Hoover administration. Corporate profits have crumbled. To date more than 1.8 million Americans have contracted the coronavirus, and hundreds are dying each day. Add to that the death of an unarmed man at the hands of a police officer which has led to daily and nightly protests, widespread anger and looting in cities across the country. You would think that would be enough to destroy consumer confidence. 

However, stocks keep climbing. The coronavirus crisis has cost some 36.5 million American jobs in two months with experts warning that figures could peak above the Great Depression in 1933, yet Nasdaq is less than 1% from its all time highs set back in February and the S&P 500 is down a mere 9 percent from its all time highs.

Economists who have studied the performance of stock markets over time say there’s relatively little evidence that economic growth matters to the outcome of the market at all. According to Ed Wolff, an economist at New York University who studies the net worth of American families, “Stock ownership among the middle class is pretty minimal.” He stated that “The fluctuations in the stock market don’t have much effect on the net worth of middle-class families.” A relatively small number of wealthy families own the vast majority of the shares controlled by U.S. households. According to an analysis by Wolff the most recent data from the Federal Reserve shows that the wealthiest top 10 percent of American households own about 84 percent of the value of all household stock ownership. The top 1 percent controlled 40 percent of household stock holdings.

Ok, this may be true but it still doesn’t take into account the psychological impact of the consumer previously presented. Even if US households own very little stock, the effects of the events we are currently experiencing are putting the brakes on consumer spending. This is already leading to a large number of insolvent businesses. This has a profound impact on GDP and will eventually impact the stock market. Or will it?

Much of the effect of the rising stock market has been explained as the effect of the money printing by the Fed. The theory is the Fed prints money, drives down interest rates which push investment into riskier assets thereby driving up the stock market. There is also the moral hazard effect whereby investors take on additional risk because they believe that no matter what happens the Fed will bailout the markets. 

The Federal Reserve President, Jerome Powell recently explained that in a liquidity crisis, otherwise healthy firms collapse because they can’t access credit. The Fed can resolve such a crisis because it can print and lend unlimited amounts of money. However, in a solvency crisis, companies can’t survive no matter how much they can borrow: they need more revenue. The Fed can’t solve that.

FEBRUARY 12: Federal Reserve chairman Jerome Powell testifies before the Senate Banking, Housing and Urban Affairs Committee on the “Semiannual Monetary Policy Report”
on Wednesday, Feb. 12, 2020. (Photo by Caroline Brehmanl)

So, despite its critical role in the economy, the stock market is not the “same” as the economy. The stock market is driven by the emotions of investors. They can exhibit irrational exuberance which normally occurs during an asset bubble and the peak of the business cycle. Equally we have seen that consumer optimism or lack thereof can impact spending, which makes up 70% of GDP, and also has an effect on stock market performance. So what we essentially have is a situation where investor exuberance is battling underlying deteriorating fundamentals. So far investor exuberance is winning, up until they take Jerome Powell’s words of caution that the Fed has no solution for business insolvency. So the stock market is not the economy but it is influenced by the economy. 

Musical chairs

John Maynard Keynes probably explained it best. According to Keynes, the stock market is not simply an efficient way to raise capital and advance living standards, but can be likened to a casino or game of chance. “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs–a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops.”