Why stockmarkets don’t always reflect the real economy

“So how is Rahul baba?” I asked my best friend Ruma when we caught up the other day.

“He is fine,” she said with a smile on her face.

“Any progress or are you guys still discussing economics?” I asked.

“Yeah, that’s the problem, plus after the last breakup I am really not sure how I should approach a new relationship,” she explained.

“Don’t worry, you will soon figure out. I mean, even if this is just on the rebound, it can’t do you any harm.”

“I hope so. But the trouble with Rahul is he gets too involved with the arguments he is making, and can’t take it when I don’t agree with him. And so we end up fighting.”

“Hah. The classic male ego at work.”

“Yeah, that’s true I guess.”

“But what did you guys fight about?” I asked.

“Oh. He was saying that the capital market is a barometer of the real economy.”

“And?”

“I said I do not agree with you,” she said. 

“Hmmm. Even I don’t. So what did he do after that?”

“Oh, he threw a fit. He said it was capital markets 101, and how could I not agree with him on such a basic thing.”

“Capital markets 101? Ye kya cheez hai!”

“The first course in any subject taught in a college or university in Australia, Canada, South Africa, or the United States is referred to as 101. Like the first course in Economics is referred to as Economics 101,” she explained.

“Oh ho! So this guy is phoren return. Interesting!”

“Yeah. He did his masters in the US.”

“Oh, his father must be Mr Moneybags then. Good for you, so after marriage you can really settle down with him,” I teased her. 

“Okay, enough of this nonsense. But tell me how can I explain to him that he is wrong?”

“Let me tell you about this economist called Hyman Minsky, who the world has re-discovered in the last few years.”

“Sure!’

“As Robert J Barbera explains in his book, The Cost of Capitalism — Understanding Market Mayhem and Stabilizing Our Economic Future, “Minsky’s thesis can be explained in two sentences: a) A long period of healthy growth convinces people to take bigger and bigger risks; b) When great many people have made risky bets, small disappointments can have devastating consequences.”

“Hmmm. Can you go into a little more detail?”

“Most of the Western economies had healthy growth rates and low inflation since the early eighties. Every time there was a threat of recession interest rates were cut. This ensured that people could borrow at low rates, and buy stuff. This helped the economy chug along decently. Of course this easy money policy, where investors could borrow and invest money in the stock market at low rates, led to the dotcom bubble in the United States. As Minsky’s thesis went, a long period of healthy growth convinced people to take more and more risk in the stock market, by investing in dotcom companies. The dotcom bubble collapsed in 2000, when the US Federal Reserve, the central bank of the US, started to raise interest rates.”

“Why are you telling me all this?” she interrupted.

“Oh, I thought this was self explanatory. Let me explain. The price of dotcom stocks went through the roof. What was it a reflection of? As George Soros writes in his book The New Paradigm for Financial Markets - The Credit Crisis of 2008 and What It Means, “Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions.””

“So?”

“Investors were buying dotcom stocks because they expected the dotcom companies to report huge earnings in the days to come and they did not expect the economy which was growing steadily to start growing at a very high rate. So the stock market, which is a part of the capital market, was going up only because investors expected a particular sector to do well.”

“Yes that makes sense.”

“Also, the investors were victims of what is known as the recency effect. Terrance Odean, a finance professor at University of California who has studied this effect, found that nearly two-thirds of trades made by individual investors are buys a day after a stock ranked among the top performers. So what this means in simple English is investors bought dotcom stocks primarily because they saw these stocks going up, and in turn convinced themselves that these stocks will continue to go up in the days to come.”

“And this had nothing to do with the so called “real” economy?” she asked.

“No it did not. After the dotcom bubble burst, interest rates were cut again. This in turn led to the next big bubble, the housing bubble.  At low interest rates, banks were willing to lend, and borrowers were willing to borrow. This led to home prices in the US and the rest of the western world going up. As the prices went up, more people queued up to borrow and buy real estate and this pushed up prices further. Basically, everybody assumed that tomorrow will be like today. As Barbera writes, “When we string together a succession of happy yesterdays, confidence in a happy tomorrow builds and risk taking flourishes.”

“So people bought real estate because they expected the price rise to continue, rather than the “real” economy to do well,” said Ruma, understanding the fundamental point I was trying to explain.

“Yeah. All this buying led to what is now known as the Minsky moment. The Minsky moment happened when investors who had borrowed too much to fund real estate purchases were forced to sell their homes to pay back their loans. As more and more people resorted to this, real estate prices crashed. This is where Minsky’s second point comes in: when great many people have made risky bets, small disappointments can have devastating consequences.”

“That is interesting.”

“In fact, people had also taken out home equity loans against their real estate purchases other than the home loans they had borrowed to fund these purchases. Home equity is essentially the difference between the current market price and the outstanding home loan. So if the current market price of a house is $300,000 and the home loan outstanding is $200,000, the home equity works out to $100,000. Banks were ready to give loans against this as well. So people took out home equity loans and bought a lot of goods and services, which in turn boosted the earnings of companies and hence the “real” economy.”

“Oh, that’s exactly the opposite of what Rahul was trying to say,” she said with a smirk on her face. 

“Yes it is. In fact, after this huge real estate bubble burst throughout the Western markets, central banks all across the world started printing money and pumping them into their economies. The hope was banks would lend this money, people would borrow it and spend it and the economies would be on their way to recovery again.”

“But that did not happen?”

“Not at all. The banks were once bitten and twice shy and hence were unwilling to lend. In fact that money found its way into the various stock markets around the world, and the markets rallied. This included markets in the US and Europe. Now the real economy was in a bad shape, but the markets were rallying. This included various commodity markets as well.”

“So it was rather dumb of Rahul to say what he did.”

“Sure it was. In fact interestingly, the second round of money printing in the United States known as quantitative easing II or QE II, comes to an end on June 30, 2011. Since QE II started the US government is meeting nearly 70% of its fiscal deficit through printing money.  Fiscal deficit as you would know is the difference between what the government earns and what the government spends.”

“So?”

“The question is whether it will continue to print money? If it does, the stock markets around the world will continue to rally because of this fresh money flowing in. Again a situation where the stock market will rally because of the money flowing in and not because of any investors expect any progress in the “real” economy,” I explained. 

“What if they don’t print?”

“Oh, then the chances are that whatever little growth that the US economy is seeing will come to a standstill. And so, the financial economy will impact the real economy.”

“So all the 101 stuff from Rahul is wrong?” she asked.

“Well, what I would say is that it’s not all correct. Economics is not physics, even though Rahul would like us to believe so. The financial economy has an impact on the real economy and the real economy also has an impact on the financial economy.”

“It sure does!”

“But tell me something, did this Rahul guy, come back to India after attending only the 101 course?”

“That is such a mean thing to say,” she said.

 —The author works in the financial services industry
and can be reached at
chandniburman@yahoo.com)