The December disaster on Wall Street caused many people to question how the stock market reflects the economic health of the U.S. and world economies.
Many don’t understand why there is a stock market, and what the stock market represents. The market sends out a variety of signals to various people at various times.
Companies that need money can issue various types of securities. Often, they issue promissory notes in the form of bonds. However, common stock or equity represents ownership of the corporation. The compendium of all these equities is traded on a stock market. The New York Stock Exchange is the world’s largest equities market.
For most people, including President Trump, the stock market is a symbol of the economic health of the nation. This is not correct. The stock market is an indicator of how successful or unsuccessful companies are in terms of how much money they make. The key word is earnings. The price of the stock is generally representative of some multiple or ratio of its earnings. The multiple usually is determined by how investors assess the industry and the risks inherent in that industry.
To gauge movements in the stock market are the market averages. The most often quoted index is the Dow-Jones Index (or The Dow), which represents the average of 40 leading (Blue Chip) companies. A second, perhaps more accurate index is the Standard & Poor’s 500 (S&P 500), which represents a portfolio consisting of 500 companies. A third index is the NASDAQ, which stands for National Association of Securities Dealers Automated Quotations exchange. Stocks on the NASDAQ are often smaller, newer and more technology-oriented companies.
The first thing the stock market represents is company performance. For example, if an industry enjoys a 20-to-1 price/earnings (PE) ratio, and earns $5 per share, it should have a market price of about $100. More speculative, growth-type companies and industries generally enjoy a higher PE ratio. Less spectacular, more income based, high-dividend companies generally enjoy a lower PE ratio.
Reaction to News of the Day
A second thing stock market reflects is a reaction to economic news of the day. If, for example, employment rates exceed the expectations of the experts, there is a good chance that the stock market will reflect this bullish news. If on the other hand the actual numbers do not fulfill expectations, stock prices might be expected to go lower.
Store of Value/Inflation Hedge
A third aspect of stock market fluctuations is tied up in the concept that the stock market is a store of value or hedge against inflation. If inflation is high, stock prices and PE multiples might reflect elevated stock prices. Stock portfolios are assets just like gold coins and real estate that can reflect expansion and compression of the economy.
A fourth aspect is the belief the stock market reflects the future economy, or is a “leading indicator.” This means that today’s stock market reflects the economy six months from now. That is why often when the current economy is strong; if the stock market goes lower it might mean that professional investors foresee a weaker economy six months from now. At the same time, when the economy is in a deep recession, an unexplained rise in stock prices might mean that investors believe that six months from now, the economy will improve.
Tool for Speculation
A fifth aspect of gauging stock prices is speculation. Sometimes out of the clear blue stock prices will go into a nosedive for no apparent reason. The Dow or the S&P 500 might appear to crash. These can be considered manufactured mini stock market crashes. What’s simply happening is that Wall Street professionals are looking for opportunities to make money by causing prices to fall. If these professionals did this in a smoke-filled room it might be interpreted as being illegal collusion. But these speculative rises and falls of the stock market are mostly done serendipitously and, in the end, stock prices generally will return to the level before the speculative storm.
A sixth point of consideration is Interest rates, Higher interest rates generally are reflected in lower stock price, and lower interest rates are generally reflected in higher stock prices. The Federal Reserve System controls interest rates (the Fed). Therefore during the December-to-remember stock fall, President Trump talked of replacing the head of the Federal Reserve. This sent stocks lower. While the president can appoint the head of the Fed, it would be most improper for the president to “fire” the Fed chairman.
Investors Hate Indecision
Investors that buy and sell stocks like and dislike certain aspects of the economy. The stock market hates indecision. Investors like to buy when they are confident that the economy knows where it’s heading. When the president or the Congress or the courts are inconsistent in their actions, the stock market interprets that as indecision, and investors prefer to wait on the sidelines until that indecision s cleared up.
How a company or the economy meets expectations is crucial. If a company is expected to earn 75 cents per share in a quarter and it earns 65 cents per share, the stock price might plummet. If, on the other hand, it earns 85 cents/share, the price might rise dramatically—the same goes for the economy. If Wall Street expects 200,000 new jobs in a month and the actually number is 125,000, this is bearish. A report of 250,000 would be bullish.
One thing is for sure, it’s virtually impossible to predict the stock market. In many ways, the stock market might be compared to a day at the racetrack. Predicting today or tomorrow’s winners is virtually impossible. What we can do very well is explain why something happened after it happened.
Thus the stock market reflects many economic factors. Unlike pure speculation, such as casino gambling, wise professionals can possess additional insight into things like corporate earnings and economic performance. But what is happening on the world stage, personalities of world leaders, acts of nature and general uncertainty make the stock market virtually impossible to predict.