How Rising Stocks Lift the Economy

We often talk about how developments in the economy will impact the stock market, but we rarely discuss the other side of the relationship: how the market impacts the real economy.

It does, and the current run-up in stocks is very positive for the economy. Here’s are three reasons why:

1. Banks can loan

Financial stocks have doubled from their lows. This is great news for banks — they were able to capitalize on higher stock prices and issued $85 billion of new common equity in one month. Some of the newly issued equity will go to pay back TARP money from the government; some will allow banks to boost their balance sheets so they can swallow more losses that are coming their way from mortgages, credit cards, commercial real estate, etc.; and whatever is left will go to originate new loans.

Since banks use leverage, equity funds will allow banks to generate new loans in the multiple of 15-20 times of issued equity. Of course, banks have to be willing to lend and consumers/corporations will need to be willing to borrow, but that is a different story.

2. CEOs have reason to hope

We think of corporate management as rational, numbers-driven individuals, and some of them may be all that. But they are still just well-paid, well-dressed and well-spoken members of that species that we call humans. As such, they are susceptible to the pressures and influences of their external environment.

The stock market has great influence on their decisions. The recent stock market rise made them question how much downsizing they really want to do. In other words, in the absence of the stock market’s positive influence, management possibly would have been laying off more people that they’ll be actually laying off.

Of course, some corporate managers simply realized the impact that the stock market has on decisions of other managers and adjusted their behavior accordingly.

3. Have job, will spend

Finally, consider the employed consumer – the driving force of the economy, the one who still has a job, the 92% of workforce. They see the Dow climbing, hear the media going hysterical over the green shoots and hear fewer people discussing the end of the financial world. Suddenly Dr. Death (my nickname for economist Nouriel Roubini, whose more common Dr. Doom nickname was misappropriated from Marc Faber) is not as popular as he was two months ago.
These employed consumers are feeling better about their future and may actually start spending money. (Those who are unemployed are unlikely to change their behavior, as the job market is very tough.) I don’t think we should expect a repeat of the 2000-2007 spending spree, but maybe they’ll start putting butter on the popcorn when they watch DVDs at home,

George Soros has a name for what I described above; he calls it reflexivity. To me it just sounds like a self-fulfilling prophecy – stocks go up because the economy is expected to do better, the economy does better because stocks went up. Of course, everything I said works the other direction, too.

Comments

[Mistrofan:]

Yes - fully agree - but in the same the global economy is walking on the edge (most of the bets being on China recovery). That means increased risk due to:
- any sudden change can kill the markets and, accordingly, the sentiment;
- if anything goes wrong with China all the bets are off (is like in portoflio theory - the market bets on just one item - China - and that might not be prudent from a diversification perspective).

Jun 07 09:17 AM

[Dave Wrixon:]

I wouldn't worry about China. If the market does not come up with the goods in terms of income returns, the capital appreciation will evaporate very quickly. Yes, I am sure that pumping up the capital ratios of the banks is behind this somewhere, but at the end of the day they are not going to lend to businesses that cannot repay. The banks fully understand the nature of this charade. They created this illusion to get themselves out the shit. It seems unlikely they are going to jump straight back in because they have got sucked in by their own hype.


On Jun 07 09:17 AM Mistrofan wrote:

> Yes - fully agree - but in the same the global economy is walking
> on the edge (most of the bets being on China recovery). That means
> increased risk due to:
> - any sudden change can kill the markets and, accordingly, the sentiment;
>
> - if anything goes wrong with China all the bets are off (is like
> in portoflio theory - the market bets on just one item - China -
> and that might not be prudent from a diversification perspective).

Jun 07 09:52 AM

[ed233:]

Is this a hope spin you're providing because I'm not convinced? I hope the retail investors who bought shares in those companies you mention haven't been duped because they swallowed those yellow shoots with intentions of bearing fruit. When the government money ran out of money they went to plan B to provide stress tests and green shoots. Who was left to hold the bag? Create live shoots and dubious stress tests to warm up the waters for the ordinary investor to jump in. China certainly wasn't taking the bait. Let's hope that this investment does not go into a sucking sewer because the only justification for all of this investment is one of follow the leader and you'll make a good investment. I'll leave my money elsewhere thank you. LOL Looking after your money.

Jun 07 10:57 AM

[Chandragupta:]

Stock markets hog a disproportionately large share of the media, and hence those in power have a vested interest in keeping the markets up. It is their job to keep up the spirit of the people, else things will be worse, it is believed. Hence we see all these sentiment boosting measures, such as the bailout of Wall Street using tax payer’s money, change of accounting rules to favour the sinking Banks, the sham “stress tests” and so on. However, rising stocks can pep up the economy only to a limited extent. Eventually, if the economy does not do well, stocks will reverse direction and the earlier rise will be proven a bubble. I don’t think even those who have jobs will go on a spending spree when there is gloom all around – they see that others have lost their jobs, price of their most valuable asset – the house – has fallen and even the stocks have risen only in the context of the March lows. But how many people have invested during the March lows? Most of the portfolios are still at a loss.

Jun 07 11:26 AM

[AuGod!:]

However unpopular in financial circles, we are probably looking at negative PE ratios in the next year. How is that relevant? Keeping it simple, think of your local coffey-shop with 35% fewer customers than last year and looking at a further 35% fewer next year than this year. A Wall Streeter might argue that the actual numbers of the drop may be slowing but the direction is clear to most of us and while statistically relevant, the Wall Streeter's take is laughable on many levels. To quote: "Mathematically, there are only two ways for a ratio of this form to have a negative value: 1.The numerator falls below zero 2.The denominator falls below zero. In the case of the P/E ratio, it is impossible for the numerator to fall below zero because this represents the price of the asset. However, the denominator, which is equal to the earnings of the company, can become negative. EPS values below zero mean that the company is losing money and is the reason why it is possible to have a negative P/E ratio."
Negative PEs, reported or not, mean that the supply of goods and/or services of those firms, exceeds demand thus my conclusion that present share values of those firms within the general markets are not supportable. Considering the condition of our economy, I will leave it to you to pick and choose but overall, I can easily imagine a further 35% correction before bottom. In the end it could be likened to shaking fleas off the dog except that in this case, once done, it will show that they can neither fly nor walk. But they can always crawl for a bail-out I suppose.

Jun 07 02:45 PM

[geewow:]

I am not sure what brand of Kool-Aid you are drinking, but you need to kick the habit!

Jun 08 11:21 AM

[Alphameister:]

The "wealth effect" is certainly not a new concept, and your point is well taken. For those whose spending is unrelated to the value of their homes, a stock-market rally of more than 35% will, indeed, help them to feel more disposed toward discretionary consumption, which, in turn, will benefit the economy. Does that mean we are off and running on a new boom? Of course not, only that we are somewhat better off today than we were a few months ago.

Jun 08 12:00 PM