Stock Market and Macroeconomics
Traditionally, macroeconomics has not paid much attention to the behavior of the stock market. An article from Professors Stanley Fischer and Robert Merton concludes that “macro analysis should give more attention to the stock market.” After the Great Recession, more attention has indeed been paid to the stock market behavior. There are many reasons for this. One reason is that there was a stock market crash in 2008 and 2009. This was on top of a crash that occurred in 2000 and 2001, and that was on top of a crash that occurred in 1987. In comparison, during the 20th century there was only one major crash before World War II—the famous crash of 1929. The point is that with the rise of Keynesian economics, stock market crashes have become more frequent. There seems to be a connection between Keynesian economics and the stock market crashes and we will study this in detail in the next chapter.
Another reason is that in spite of these crashes many more families have invested in the stock market compared to 1920s. Therefore, stock prices play a larger role in the prosperity of the nation. Yet another reason is that central banks around the world become nervous when share prices fall and their policies are tied to stock market performance. Whenever, stock markets crash, bankers immediately cut the federal funds rate and the market interest rates fall immediately. This was done by Alan Greenspan when the market crashed in 1987, and again in 2000. Ben Bernanke did the same in the market crash of 2008 to 2009. The rest of the world also cut interest rates sharply. Therefore, central bank behavior has become predictable because it has been tied to share prices.
5.1 The Efficient Market Hypothesis
Professor Eugene Fama offered a well-known theory for stock market behavior. It is known as the efficient market hypothesis (EMH). According to this theory, stock markets are efficient and incorporate the entire relevant information about the economy. Therefore, it is futile to try to beat the market through frequent trading or market timing, as share prices are always at their fair market value. It is then not possible for people to buy stocks below the fair market price or sell them above the fair market price. Most money managers who manage other people’s money frequently buy or sell shares on behalf of their clients in the belief that they can outperform the average market price, but according to EMH this is not possible in the long run, though in the short run, a few money managers may outperform the market by taking advantage of some bargains. This happens if money managers buy risky stocks, but there are chances of losing money in a big way.
Since most money managers charge a commission for their trading shares, they are not fond of the EMH idea. Well-known tycoons like Warren Buffet have produced larger returns than the market average and become multibillionaires in the process. Their success shows that buying undervalued companies and making them profitable is a better investment strategy than buying stocks that represent the market average. But Warren Buffet is an exception and very few money managers can match his performance. A study by Morningstar shows that less than half of the money managers outperformed the market average over time. In other words, buying an exchange-traded fund (ETF) like SPY that represents the Standard & Poor’s index would have been a better investment strategy than handing over money to some expert manager. Thus, EMH idea has a large number of critics and supporters but a few money managers believe in it.
5.2 Stock Market and the Economy
Share prices are related to the profits of firms and these profits depend on the state of the economy. If the economy grows, firms make good profit and their stock prices rise. But the economy cannot grow if the firms do not grow. So, the fortunes of firms and the economy are interconnected. Then what comes first—the growth of the economy or the growth of the firms?
Since the economy is made of firms, the growth of firms must create the growth of the economy. In order to grow, the firms have to invest more money in their companies. They may do so from their profits or from borrowed money. But the increase in investment occurs only if the firms are already making a good profit. Thus, profitable firms create not only a good economy but also high stock prices. This argument shows that when stock prices are high, the economy grows at a faster pace.
5.3 The Wealth Effect
The stock market affects the people and the economy in many ways. One of them is known as the wealth effect, which refers to the effect of a change in the value of one’s wealth on spending. As stock prices rise, people feel richer even if they do not sell their shares. So, income does not rise from capital gains, but the wealth seems to rise from paper profits, which makes them spend more on goods and services. As consumer spending rises, output goes up and more jobs are created. This argument became very popular after 2009, when stock prices began to rise even when unemployment kept rising, as central bankers around the world thought that the printing of money would bring down interest rates, which makes stocks more attractive relative to other assets like bonds and savings accounts. The heads of European Central Bank and the Federal Reserve argued that the stock market optimism will create general optimism and will make people spend more. This would then raise output and employment.
This was also why Alan Greenspan had lowered interest rates sharply after the worst stock market crash in 1987, because a stock market crash has far worse wealth effect than a stock market rise. When stock prices rise, people start to buy luxury goods and borrow money to buy them. But if the stock market crashes, the paper profits go away and the debt stays. High debt along with the disappearance of paper profits make people very pessimistic, which results in consumer spending falling sharply. This is what happened in 1929 and led to the Great Depression.
However, such arguments have their critics, who argue that since stock market gains go mostly to the rich, who have a low marginal propensity to consume, the wealth effect of rising stock prices has an insignificant effect on consumer spending. They argue that rising home prices that make people feel more optimistic have larger effects on consumer spending. Such is an argument given by Dean Baker, author of The End of Loser Liberalism, at Center for Economic and Policy Research.
5.4 The Investment Effect
High stock prices also raise business investment, especially in an economy with rising optimism, because many firms make profits by selling stocks and in turn have more money to invest more. This is also the positive effect of rising stock prices. But the effect may be reversed, as in 1929, if the stock market falls sharply.
5.5 Pension Funds
There are many companies that manage the pension accounts of their clients and expect high returns for these. One of the reasons why a larger population is involved in stock markets now is because either they or their funds have sold bonds and bought shares, as bonds now offer very low interest rates. Stock owners believe that the government will support the stock market in case of a big fall. They have witnessed similar situations in 1987, 2001, and ever since 2009.
5.6 Anticipation Effects
While the current state of the economy has a strong effect on the stock market, the economic future sometimes may have an even stronger effect. On one hand, the stock market begins to fall if the economy slows down or a recession is expected. On the other hand, if the future looks better, the stock market starts to rise even before the recession is over. When the government starts printing money and increases its deficits, production rises gradually, but the stock market rises in anticipation of increasing production and employment.
5.7 The Rate of Interest
The rate of interest has a very strong effect on the stock market for many reasons. First, there is an inverse relationship between rates of interest and bond prices. At low interest rates, bond prices are high, due to which bonds become less attractive compared to stocks. Second, low interest rates tend to increase consumer spending and business investment, so the economy becomes stronger which in turn raises the stock market.
5.8 Modern Portfolio Theory
Another theory that offers investment advice to people is known as the modern portfolio theory or MPT. According to MPT, an investor should diversify his or her portfolio of stocks to minimize the risk associated with the stock market investment. In the long run, stocks offer a much higher return than many other investments like corporate and government bonds, and for this reason, people like to have a part of their money invested in a variety of stocks. But occasionally, a company may fail and declare bankruptcy, and if a person has invested all the money in that company that person may lose all his savings. For this reason, the MPT suggests to buy a variety of stocks so that if one company fails or does not live up to expectations, others may perform better than the failing company. In this way, an investor’s overall stock portfolio could still show strong results.
The diversification should be done not only among various stocks but also among various assets. Thus, an investor may put some money in stocks, some money in bonds, and some money in other assets, such as gold or real estate. In general, bonds are less risky than stocks and offer a fixed return, whereas stocks offer dividends that are usually below the return on bonds. But stocks offer a possibility of appreciation over time; although bonds can also appreciate when the interest rates fall, that appreciation is limited. So, in the long run, the stock returns have been higher than bond returns. According to MPT, an investor should diversify among stocks and buy some bonds and perhaps other forms of assets too.
5.9 The Random Walk Theory
Another theory offering investment advice is the random walk hypothesis that was proposed by economist Professor Burton Malkiel. This theory argues that stocks behave randomly and the previous performance of any stock is no guarantee about its future performance. If a stock has done well in the past, it does not mean it will do well in the future. Stock prices are random and follow an unpredictable path.
Like the EMH, the random walk theory also believes that stock markets are efficient and incorporate the entire available information in the prices of different stocks. Therefore, it is not possible to do better than the stock market average price through active-portfolio management or market timing. Risky behavior may lead to higher returns but it can also produce big losses.
In an article in the Wall Street Journal in 2017, “Index Funds Sill Beat Active-Portfolio Management,” Professor Malkiel presented evidence in support of this theory. He wrote that, “During 2016, two-thirds of active managers of large capitalization U.S. stocks underperformed the S&P 500 large-capital index.” He added, “More than 90 percent of the active managers underperformed their benchmark indexes over a 15-year period.” Thus, the random walk theory advises the investor to put money in a diversified index fund and not in actively managed funds.
5.10 Adaptive Markets
Stock market theories can be divided into two categories. Some people believe investors and stock markets are rational and efficient, whereas others believe that stock markets and investors are irrational and emotional. When stock prices rise for some time, people start to believe in EMH; when they crash or fall sharply, the irrational and emotional theory becomes popular. In a 2017 book, Financial Evolution at the Speed of Thought, Professor Andrew Lo argues that both views are correct. During good times when investors make money year after year, everyone likes the stock market and believes in the rationality principle, but during bad times when people lose a lot of money in the stock market they regret and consider their behavior irrational.
Professor Lo writes:
From the mid-1930s to mid-2000s, a period of relatively stable financial markets and regulations, the assumptions (of the efficient market hypothesis) offered reasonable approximation of U.S. financial markets.
the Adaptive Markets Hypothesis, however, tells us that long periods of market efficiency and stability are not guaranteed: They depend on the stability of the overall environment. When there are big changes that have significant impact on that environment-including political, economic, social, or cultural shifts-markets are going to reflect those changes. (p. 254)
Almost everyone agrees that a major change has occurred in the economic and financial environment since 2007 when the Great Recession started. The Federal Reserve and other central banks believe that stock markets are indicators of a strong economy. Whenever stocks decline continuously even for a short period, banks become nervous and hold press conferences to assure investors that they would continue to print money. They call their policies Quantitative Easing (QE) and so far, there have been three rounds of QE—QE1, QE2, and QE3. These rounds brought the federal funds rate to nearly zero and kept them constant till 2015. The Federal Reserve raised the rate to 1.25 percent by 2017, which was still very low. This kept the QE going. In Europe and Japan, interest rates even turned negative and remained so even in 2017.
Investors adapted themselves to this new environment where the central banks would move to support share prices whenever there was even a short period of stock decline. Since bonds had already become expensive because of very low interest rates, stock prices broke many records. This is an example of adaptive markets. The investors came to believe in the theory, follow the Fed, or don’t fight the Fed. According to a financial writer, John M. Mason, “During the economic recovery from the Great Recession, the Federal Reserve has been very vocal in its support of the stock market and its desire to see stock prices increase.”
Summary
This chapter deals with the inter-relationship between a nation’s stock markets and its economy. The two depend on each other. When the firms are profitable, output rises and the economy grows at a fast pace. Similarly, when the economy grows fast, firms become more profitable.
There are many theories of how stock markets behave over time. The efficient market theory says that stocks are always priced at a fair market value, so that a passive investment strategy is good for investors, and nothing is gained from frequent buying and selling of stocks. This is also the belief of the random walk theory. But there are those who believe in market timing and active management of their portfolios. Finally, according to the adaptive market hypothesis, stock markets are rational and efficient most of the time, but when markets begin to fall, investors become emotional and cautious. They then adapt to the new environment.
Bibliography
Amadeo, Kimberly. The Great Depression: What Happened, What Caused It, How Did It End? The Balance. August 11, 2017. https://www.thebalance.com/the-great-depression-of-1929-3306033
Dean, Baker. The End of Loser Liberalism, Center for Economic and Policy Research, 2011, p. 18.
Lo, Andrew W., Adaptive Markets: Financial Evolution at the Speed of Thought. Princeton University Press, New Jersey, 2017.
Malkiel, Burton G. A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book. https://pdfs.semanticscholar.org/5a26/4c944640613fdc887d72e3c3da0445e3e37c.pdf
Malkiel, Burton G. Index Funds Still Beat ‘Active’ Portfolio Management. There Is No Better Way for Individuals to Invest in the Stock Market and Save for Retirement. The Wall Street Journal June 5, 2017. https://www.wsj.com/articles/index-funds-still-beat-active-portfolio-management-1496701157
Mason, John M. Stock Market Performance: Index Funds And Federal Reserve Policy. Seeking Alpha, June 7, 2017. https://seekingalpha.com/article/4079542-stock-market-performance-index-funds-federal-reserve-policy
Mauldin, John. Modern Portfolio Theory 2.0: The Best Investment Strategy Today. Forbes, June 1, 2017. https://www.forbes.com/sites/johnmauldin/2017/06/01/modern-portfolio-theory-2-0-the-best-investment-strategy-today/#43892be41f8f
Ro, Sam. Nobel Prize Winner Eugene Fama Explains Why You Have No Chance Of Beating The Market. Business Insider, October 14, 2013. http://www.businessinsider.com/2013-nobel-prize-in-economics-2013-10