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The disconnect between the stock market and the economy

Posted by admin on September 17, 2009 in Investment Information

Stock markets tend to be used by some as proxies for the state of the general economy given it is a readily and easily available source of information to rely upon where the “score” is kept daily. But is this really a good barometer of our economic health?  The answer is most likely not.

As Canadian Financial DIY wrote about recently, there appears to be no relationship between a country’s GDP growth and stock market returns and, in fact, there may actually be an inverse relationship between economic growth and stock market return. Assuming the studies are right, cheering for the NYSE or TSX to keep going up may actually provide small solace to you and I (and so much for investing in your BRIC ETFs).

The explanation is manifold. Foremost, publicly traded companies have a very narrow band of stake-holders. In essence, they are built to serve the insiders, shareholders, bond-holders/lenders. Full stop. As a result, the wealth of a publicly traded company is spread rather thinly among a small band of the population.

How small? The Federal Reserve’s study “Changes in U.S. Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances” found 17.9% of American households surveyed owned stocks, 15.9% of American households surveyed owned pooled investment funds and 34.6% owned retirement accounts in 2007 (I am assuming stocks would be kept in those accounts and the 17.9% references stocks held outside retirement accounts).

Thus, the ubiquity of conversations about stocks in personal finance blogs masks the fact a minority of households actually own stocks and any gain in the stock market is beneficial to a small subset of the population.

In comparison, collective GDP growth is, obviously, an aggregate of publicly traded companies, private companies, public sector and consumption growth which is much broader in scope. Since private companies are not subject to the same disclosure requirements as their public counterparts, it is always hard for the media to speak about private companies. But, if you worked for such large private concerns as Koch Industries or the Jim Pattison Group of companies, you would know first-hand that private companies are just as productive and profitable as any enterprise.

If there truly is a disconnect between the stock market and the economy, there are several implications going forward:

1. Blindly buying stocks in emerging economies may not be a prudent strategy. Many emerging businesses in emerging countries (and let’s assume in emerging economies the stock exchange is also not very mature and established) tend to be private or partially or wholly government owned (see Saudi Aramco, Petrobras, Huawei). Thus, GDP growth may actually be going into government coffers or into private hands and not to shareholders of publicly traded companies.
2. Experts may mistime calling an economic recovery simply by looking at the stock market. In other words, it is not enough to look at the headline but why people think the recovery is here.
3. Market gains = social strife? In the mid-1990′s, many people began to voice concern that publicly traded companies, especially banks, were making billions in profits while a jobless recovery was occurring. If the market continues to trend up, the dialogue could shift from the stability of the financial system to what, if any, social responsibility publicly traded companies have especially, unlike the 1990′s, taxpayer money was used to bail out many publicly traded businesses. I suspect Michael Moore’s movie about capitalism is the opening salvo in a long war. I don’t know if any bankers read this blog but you may want to dust off the pr hand-book from the mid-1990′s and amend accordingly.