City Socialist explains why we shouldn’t look to stock indices for guidance on the real economy — markets don’t care about us and we shouldn’t care about them.
It’s often said that the market can remain irrational longer than one can remain solvent and that markets don’t care about one’s feelings. Nevertheless, very serious people on television and in print talk about “stocks going up” or “the market crashing” and it is clear how they feel. When stocks go up, it is because things are good, and if they fall it it because things are bad. Rarely is this association challenged.
The Brexit conversation follows this predictable pattern. The Brexiter highlights the stability of British markets as proof that all is well. The Remainer, in turn, points to US stocks rising faster and sees proof that Brexit is a disaster. I see the same conversations playing out among financial professionals – at least among those without much skin in the game. If markets rise, the news must be good, if they fall, bad.
But, those of us with more skin in the game can’t afford to indulge such loose thinking.
Stocks are financial assets – the right to get some money in the future. They represent an ownership slice of a company and a claim to a part of that company’s profits.
Contrast this to a bond, which represents a claim to a fixed amount of money from a particular entity at a particular time.
The question is always: how much are people willing to pay for that right?
Stock indexes sound serious and important… They move a lot, and noise is good for pundits. This makes for a powerful generator of spin and nonsense.
The textbook answer is that investors look at two things: the amount of money they expect to get by holding the asset, and how much they value money now versus money tomorrow.
If we are talking about an index such as the FTSE 100 leading shares, the amount they expect to get is corporate profits across the entire economy, as the companies that it consists of are involved in almost every kind of economic activity. It is tempting from this perspective to say that more profits must mean more economy, which must mean good things are happening – i.e. if stocks go up, investors must believe things are getting better.
There are many reasons why this isn’t the case.
Four Reasons Stock Market Rises Don’t Mean a Better Economy
The first is the first part of the ‘textbook answer’ above. If stock prices go up it may be that investors are keener on money in the future than money now. That has little to do with optimism or pessimism about the economy. It is a function of rational (or not) beliefs people have about how much money they will want in the future and how much they are prepared to let go now.
Second is the complex relationship between profits and the economy. Anything that makes it harder or easier for companies to capture profits will change the relationship.
The EU imposes many rules on companies – restricting monopolies, stopping predatory pricing practices and banning discrepancies in cross-border pricing. Good or bad, this has an impact on profits for a given level of economic activity. Leaving the EU may hurt trade or shrink overall economic growth, but it may also give domestic companies freer reign to take a bigger slice of the national economy. If stocks rise thanks to this, it is hardly an endorsement of Brexit.
Third is the thorny problem of money. Profits are not made in steel, grain and haircuts but in Pounds Sterling. Companies sell real things and have real assets. If the value of the pound falls in comparison to other currencies then the price of those things rises. Profits can increase selling the same amount of things to foreigners for the same amount of foreign currency, but more pounds. No new output, but more profits. FTSE100 companies have plenty of foreign assets and income, so they are worth more pounds if the pound falls.
However, a falling pound also means higher prices for products consumers buy from abroad. Given Britain is a major importer of goods, rising profits are likely to go hand-in-hand with misery for consumers. The price of money can change relative to domestic goods and services too – which is what we call inflation or deflation. Inflation can inflate profits at the same time as reducing the number of goods and services workers can buy. Misery for most people and higher stock prices would be the result.
Fourth is that our textbook answer is missing half of the story. Asset prices are determined by investors’ ability to buy, as well as their willingness. There are myriad influences on this that have nothing to do with how the economy will perform in the future.
Then there’s leverage. Banks can lend investors money to buy stocks, even if they aren’t doing it on purpose. If a bank lends me money to buy a house and I end up spending less on rent and putting money in my ISA, it is funding my stock buying. And, whilst banks don’t tend to lend to you or I to buy stocks, they sure do lend to asset managers and hedge funds – it is one of their favourite things to do. The more of this they do, the more prices can rise without any change in anyone’s expectation of economic activity.
Stay Rational – and Solvent
Finally, there are two things that most pundits seem to ignore.
The amount of economic activity in the G10 countries has risen for many decades. All things being equal (even though we have established they aren’t) we should expect stock markets to reflect this. Second, interest rates have been falling for 40 years. That represents a trend change in the “money now versus money later” question that investors face.
Stock indexes sound serious and important and most people take it as read that they represent the overall economy. They move a lot, and noise is good for pundits. This makes for a powerful generator of spin and nonsense.
what the papers don’t say
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If one looks at a long-term chart of any stock index, the big political events can’t be seen. Instead, the peaks and troughs are events of the markets’ own creation. Manias and panics are as old as finance, yet markets have always taken massive political changes in their stride.
Brexit will impact most of us. It has dominated the political and cultural landscape for years and will continue to for the foreseeable future. This impact won’t be offset by the price of shares of companies you don’t own going up, nor tarnished by the opportunity to buy shares in those companies for less.
I suggest that, if markets aren’t prepared to care about our feelings, we’ve no reason to care for theirs – and every reason instead to stay rational and solvent.