To every action there is always opposed an equal reaction — Sir Isaac Newton
A couple of weeks ago, I wrote an article about the seemingly irrational U.S. stock markets. In the piece, I cited the general belief amongst economists that the first quarter contraction — annualized to a final, revised -2.1% — was largely due to a very rough winter, and that the second quarter was expected to be better.
However, despite the short-term gyrations, the booming stock market has appeared to fly in the face of historically subnormal growth over the five year-old economic recovery.
After second quarter GDP growth was revealed to be a strong 4.0% (annualized), one might think investors would cheer and pull out their checkbooks, looking to snap up more stocks.
Instead, the reverse was true: The day after the data was released, the Dow Jones Industrial Average fell 317.06 points. The Nasdaq composite lost 93.13 points, and the S&P 500 dropped 39.40 points. Worse still, all three exchanges have continued to trend downward.
To understand how the stock markets work, we have to start at the basics.
Like All Goods and Services, Stock Prices Are Based on Supply and Demand
Stocks are, simply put, traded money. When demand for a particular stock rises, more of it is purchased, increasing its value. Conversely, as demand falls, so does the price. Contemporary economist George Reisman developed a formula which captures exactly how prices are set:
In the above formula, Price (P) is determined by the ratio of Demand (D) and Supply (S). If Demand rises while Supply remains constant, Price must increase. If both go up, the net effect on Price could be positive or negative, depending on the rate of increase for each. If Supply decreases and Demand remains constant, Price goes up.
Clearly, the demand for stocks during the current bull market has been strong. But why?
Quantitative Easing Created Demand
According to Investopedia, quantitative easing is defined as follows:
An unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Quantitative easing is considered when short-term interest rates are at or approaching zero, and does not involve the printing of new banknotes.
In a series of aggressive efforts to reignite the economy over a 3 1/2 year period, the Federal Reserve flooded the economy with liquidity (cash) by purchasing bonds. At its peak, the latest iteration (colloquially known as QE3), involved $85 billion of monthly purchases.
The Fed’s monthly purchases achieved the desired result of driving bond prices higher, which caused interest rates to fall. With interest rates on short-term Treasuries dropping like a rock and hovering at near-historic lows for the better part of five years, the only significant source of liquid investments offering the potential for attractive returns was the stock market. Therefore, demand for equities soared, pushing the Dow to a series of record highs.
The Stock Market Was Due for a Correction
Perhaps due in part to accelerated demand caused by quantitative easing, many economists believed the stock market was becoming overpriced and was in need of a correction. A stock market correction is considered a normal part of the cycle and is commonly defined as a 10%+ decrease. It is also typically short-term in nature, as investors cash in some of their profits but maintain bullish overall.
“We’ve been on a strong run,” according to Jerry Braakman, chief investment officer at First American Trust. “There’s just more concern that stock valuations are rich compared to historical norms.”
The current declines in equities have yet to reach 10%, so despite the good economic news, there may be more to come before buyers return in full force. As to which direction the markets are going over near term, it’s anyone’s guess. Some economists believe the current bull market is far from over; others are expecting an impending crash.
GDP Good News Can Actually Be Bad for the Stock Market
Although higher GDP growth generally indicates improved corporate earnings and often spurs demand, by no means is it perfectly correlated with a rising stock market. In fact, in this case investors are justifiably concerned that the Fed will begin raising interest rates sooner than the currently-projected mid-2015 timetable. Rising interest rates make bonds more attractive, lessening the demand for stocks, and, as the formula illustrates, lowers prices.
Furthermore, although overall GDP growth was solid, a few high profile earnings reports were less than stellar. Whole Foods and Exxon-Mobile released lower than expected second quarter results. Yum Brands (owner of KFC and Pizza Hut) did likewise, and others were lower as well. Coupled with worldwide tensions and concerns over the direction of interest rates, demand for stocks has been negatively affected.
Prospects Over the Next 12 Months Remain Positive
As of this writing, the good still outweighs the bad with respect to the stock market. Interest rates are still expected to remain low, economic growth appears to be accelerating and consumer confidence is rising. Buyers, after what seems likely to be a short-term respite, should return and spur demand once again.
However, nobody knows for sure exactly what’s in store for the stock market. As William Feather once said, “One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”