The Stock Market and the Economy's Apparent Disconnect

[TXgolfer]

When he’s talking to his fellow economists, Roger Farmer describes the stock market and the economy as “co-integrated random walks.” For lay audiences he prefers a clarifying metaphor: two staggering drunks connected by a long rope. Sometimes the stock market and the economy go in the same direction, sometimes not. But tied together as they are, they can never get too far apart. “The relationship has been quite strong,” says Farmer, a Briton who teaches at the University of California at Los Angeles. “It’s one of the most stable things I’ve seen in the postwar period.”
Keep those lurching lushes in mind as you try to make sense of the Dow Jones industrial average. It set records five days in a row in early March even though unemployment remains high, corporate profits seem to be topping out, and across-the-board federal spending cuts are beginning to bite into growth. Will the rally in stocks inspire confidence and pull the real economy higher? Will the sluggish economy drag Wall Street back to reality? Or is there still enough slack in the rope for the two to stagger along in different directions for a while?
Alas, the chance that Dow records will whip up enthusiasm for better times ahead seems slim. Ordinary Americans see a chasm separating Wall Street from Main Street. Profits, which support stock prices, have been buoyed by foreign growth and by the suppression of domestic wages. Sentier Research says the income of the median U.S. household after inflation was 4.5 percent lower in January 2013 than in June 2009, the month the feeble recovery technically began. The economy’s output is still 5.8 percent below potential, and the unemployment rate has been higher than 7 percent for more than four years.
The budget clashes in Washington aren’t just political theater; they’re fights over a shrinking pie. “As long as there’s a wedge between our ambitions and our means, the crises will keep coming back, I guarantee it,” says Jan Rivkin, co-author of a new Harvard Business School report, Competitiveness at a Crossroads. He sees the possibility of a downward spiral in which American businesses look elsewhere for growth, which could turn politicians and the public against them, making them even more likely to seek opportunities outside the U.S.
“Markets are strange,” says John Reed, who should know. He ran Citicorp from 1984 to 1998 and stayed on as co-chairman and co-chief executive officer for two years after the merger with Travelers that created Citigroup. At 74, he’s chairman of MIT Corp., the governing body of Massachusetts Institute of Technology. Reed contributed to a new MIT report called Production in the Innovation Economy. “The financial community has changed dramatically,” he says. The big banks are focused on creating investment products rather than on allocating capital to borrowers, says Reed, so manufacturers have trouble getting their attention, and U.S. production suffers as a result.
The alternate possibility is that the economy will pull the market downward, but that isn’t happening, either, thanks mostly to the strenuous efforts of the Federal Reserve. Under Chairman Ben Bernanke, the Fed is keeping interest rates superlow to encourage investment in houses, factories, equipment, and software and to make it easier for households to keep spending as they pay off their debts. The Fed is also trying to use loose monetary policy to compensate for the tightness of fiscal policy, i.e., taxing and spending, which are under the control of the president and Congress. Budget deficits are shrinking rapidly; in February, even before sequestration took effect, government employment fell by 10,000.
Bond yields are so low that savers who used to keep their money in, say, Treasuries are being driven into the stock market in search of positive returns. They have no choice.
The stock market isn’t just a hothouse flower that’s kept alive by the tender ministrations of the Fed. Market rallies can be self-perpetuating: The higher prices go, the more stocks people want to buy (as opposed to milk or movie tickets). As John Maynard Keynes observed, the stock market is like a beauty contest in which your own opinion doesn’t matter; you pick the face that you think others will choose.
That said, economic growth has to be just right—tepid—for stock prices to keep rising, says David Rosenberg, chief economist and strategist at Toronto-based wealth manager Gluskin Sheff + Associates. If the economy slips into recession, even the Fed won’t be able to keep the market aloft. On the other hand, if the economy finally catches fire, investors will conclude that the Fed’s extreme unction will eventually be withdrawn. They’ll sell bonds in anticipation, driving up interest rates and possibly pushing down stocks, Rosenberg says. That would be an echo of 1994—a good year for the economy and a disastrous one for bond investors; the 30-year Treasury bond yield jumped from 6 percent in November 1993 to 8 percent in November 1994 as bond prices plunged. The Dow managed to rise a little less than 5 percent.
Rosenberg isn’t in the camp that says the Fed is irresponsibly inflating asset bubbles, nor does he think stock prices are overvalued. His worry is simply that no one else is particularly worried—that the stock market’s rise has been so steady, calm, and untroubled. Exhibit A: The market’s prediction of stock market volatility is back to the lows of 2006 and 2007 (right before, ahem, the biggest crisis since the Depression). Says Rosenberg: “If there’s a bubble right now, it’s in complacency.”
Excessive complacency does put one on edge. Guggenheim Partners Chief Investment Officer Scott Minerd went to the World Economic Forum in Davos, Switzerland, this year with a good feeling that the global crisis that broke out in 2008 was finally over. What unnerved him was that everyone he met in the ski town seemed to feel the same way. Says Minerd: “I walked away from Davos more nervous than I’ve been since back in 2007. I hate it when everybody agrees with me.” Guggenheim Partners is placing a bet that volatility will rise by investing in an exchange-traded fund tied to the Chicago Board Options Exchange’s Volatility Index.
The stock market’s importance is more symbolic than economic. Only a handful of companies use it to raise money in a typical year, and most families have more wealth in real estate than in stocks. What higher stock prices do is signal to CEOs that investors want them to put their money to work. Farmer argues that rising stock prices may yet rouse dormant animal spirits and get the economy going again. If that’s so, then the Fed’s strategy will have worked. If not, Wall Street could be in for trouble. One way or the other, those two drunks are inseparable.

The Stock Market and the Economy's Apparent Disconnect - Businessweek