Stock market soars as economy sinks
Last week, the stock market hit a five-year high. Meanwhile, the economy seems to have hit a13-year low. Why the apparent dislocation between stockmarket values and economic reality?
The history
Divergence between the stock market and the economy isnothing new. The stock market is much more volatile thanalmost any of the numbers relating to the real economy. Theytend to pootle along at 2 per cent or 3 per cent a year. It is amajor change if they rise by 4 per cent or 5 per cent, or fall by1 per cent or 2 per cent.For stock markets, however, such changes can take place in a day - and then be quicklyreversed.The economic variable of closest relevance to the stock market is corporate profits. Our firstchart shows that huge movements of the stock market have had virtually no counterpart inmovements of corporate profits. This is especially true of both the surge in the equity market inthe late 1990s and its subsequent collapse.Incidentally, the chart shows that the equity market has run far ahead of corporate profits overthe past 25 years - appearing to suggest that the market is currently bad value. In fact, thiswould be a dangerous conclusion to draw. Everything depends upon the start and end dates.You could choose a start date from which the market had risen by less than corporate profitsand accordingly looked good value.
Economic links
So why is there such divergence between the markets and the economy? Ultimately, corporateprofits are the arbiter and bedrock of stockmarket values. But there are three other factors thataffect markets.The first is the return on alternative investments and the cost of finance, principally short-terminterest rates and bond yields. If alternative investments yield next to nothing then potentialinvestors in equities will be less demanding about what equities have to offer.The second factor is the amount of money available for investment. The more money investorshave, the larger the amount they have available for equities. The money from mergers andacquisitions is a subset of this factor. Third, is the degree of optimism that investors feel aboutthe future, and particularly about the future growth of profits.The first two factors are hard facts but the third is utterly airy-fairy.The stock market strength of the last few weeks is more about these three factors than aboutcurrent corporate profits performance. Indeed, it is important to see the equity market strengthas part of a general surge in asset prices. Investors are currently awash with cash at a timewhen it is difficult to find attractive homes.Indeed, for the first time that I can remember, I find it difficult to identify a major assetcategory that on pure economic grounds looks under-valued. Short-term interest rates are low.The real return available on short deposits is of the order of 2 per cent. Meanwhile, bond yieldsare wincingly low. At the long end, yields have touched 4 per cent.
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