One of the most common questions that I receive goes something like this: “Why should I be investing in the stock market while the economy is still on shaky ground?” This is certainly a reasonable question. After all, U.S. unemployment remains very high, the global real estate market is soft, taxes are rising, countries in Europe are on the verge of bankruptcy, the State of California is basically insolvent, and I could go on and on. So the question that begs to be asked is how, in the face of all these headwinds, can the stock market continue to head higher? How can Wall Street surge while Main Street suffers?
While many investors believe that stock prices act in unison with economic performance, the fact is that in many instances, there is little relation between the two. According to financial planner Matt Montgomery,
There has always been an interesting disconnect between the economy and the stock market. Many investors believe the economy and the stock market walk in lock step. If the economic news is good, they assume the stock market will go up. If the economic news is bad, they assume the stock market should decline. Unfortunately, it just isn’t that simple. If it were, investing would be easy. But history shows the economy and the stock market have a very uneven and bumpy relationship.
The recent global recession, while painful for the average Joe, was a wake-up call for corporations worldwide. In order to stay afloat, many companies resorted to cutting costs and trimming unnecessary organizational fat. Anticipating a prolonged business slowdown, they were faced with the option of either massively lowering costs which entailed huge layoffs and trying to weather the storm or continue to be bloated and face massive losses and eventual bankruptcy.
Former President Clinton Labor Secretary Robert Reich summed it up saying,
How can the stock market hit new highs at the same time unemployment is hitting new highs? Simple. The market is up because corporate earnings are up. Corporate earnings are up because companies are cutting costs. And the biggest single cost they’re cutting is their payrolls. So they let people go and, presto, their balance sheets look better and their stock prices rise.
While Reich articulates the process well, his cynical tone comes from his general philosophy that more government intervention is needed to solve the global economic problems. According to his view, large corporations that emphasize greed and profits over social justice are part of the problem. Without getting into a debate on various approaches to political economics, let’s just say that for investors looking to invest in companies maximizing profit, now has the potential to be a great time to invest. After all, corporations have succeeded in significantly cutting expenses and are now very lean. This means that not only are they more agile and able to quickly adapt to changes in the marketplace, but when the overall economy starts improving, they are poised to post very strong profit growth. In fact, in the midst of quarterly earnings reports, we are witnessing company after company handily beating their earnings forecasts, and the companies themselves are becoming more optimistic on their own business prospects going forward. For investors looking to make money, this is the bottom line.
The End of the World
Another reason that we could potentially see the stock market continue to climb is that it is just getting back to more realistic levels that it was at when the market crashed. In February 2009, investors and fund managers finally capitulated and sold everything in a panic anticipating the end of the world. Well, believe it or not, the sun kept rising every morning and the world continues. Investors took a deep breath and realized that it was time to be rational once again and that there was no reason for stock prices to be so low. So, they started – and continue – to buy back the stocks they had just thrown out.
Disclosure: No positions