Mastering the Market
“The matters that concern the investor most immediately are (1) the general price level, (2) interest rates, (3) business profits, (4) dividends, and (5) security-price movements.”
–Benjamin Graham & David Dodd, 1934
What Really Moves the Market?
If we can find the answer to this key question, we should be able to retire a bit quicker! Every wise market watcher and participant has their own ideas on what moves the market. Some are highly sophisticated in their academic theories, some are focused on trends in economic indicators from unemployment statistics to the consumer price index, some follow market index charts to foresee the future, and still others believe in such superstitious market forecasters as presidential election winners and hot (January) or cold (October) months for the market. Only a few market indicators have shown their value over the years.
Searching for Economic Prosperity
What every investor wants to see is how prosperous the economy will be in the coming year, as this is the stuff that moves markets (bull markets). The most general measurement of economic prosperity for a country is called its “Gross Domestic Product,” or GDP–that is, the market value (adjusted for inflation) of all goods and services produced within its borders. In 1997, the GDP of the United States was US$7.3 trillion (S$12.7 trillion).
More important than the actual GDP number is the trend. Investors want to know if the GDP is expanding or contracting, and usually talk about GDP in terms of %growth or %contraction from year to year. The Singapore government recently upgraded their GDP expansion forecast for year 2000 to about 10% (10% expansion over 1999 GDP). Over the last 40 years, GDP in the United States has averaged 3.2% expansion per year, with an annual range of +7.4% (1959) to -2.1% (1982). Thankfully, contractions are rare, with only 5 negative GDP years in the US since 1959.
Investors are also interested in various components of GDP. Like a corporate balance sheet, GDP can be viewed in terms of production (market value of everything produced from software to luxury goods) or expenditures (every citizen’s or business’ purchase of cars, furniture, clothing and such). Many economists prefer to view GDP in terms of income, where it equals the total amount of income generated by the economy including wages, rents, interest and corporate profits. From the investor’s eye, the corporate profit component of GDP is what will drive dividends and share prices.
Surprisingly, most countries show GDP being made up of about 50% wages and only 10% corporate profits. Don’t underestimate this small-looking 10% slice of the GDP pie, because the year to year fluctuation in corporate profits explain roughly 60% of annual GDP changes! Profits are the viagra that stimulate the economy.
The Role of Governments: Smith & Keynes
If we trace back the roots of modern government involvement in fiscal policy we arrive at 1776 in the USA and meet Mr. Adam Smith, author of The Wealth of Nations. Smith’s ideas were elegantly simple, that government can only interfere with the efficient operation of the economy. Nothing could cause the markets to operate with more precision than individual self-interest. So, the less the government got involved, the better the economy.
Smith’s policies were the bedrock of American fiscal policy for its first 140 years, until the great depression of the late 1920s. The government simply stayed small, balanced its budget each year with spending being related to income. This simple commonsense approach to governing, after 50 years of intermission, reemerged in the form of Ronald Regan in the 1980s. Between Smith and Regan, the US experienced 50 years of John Maynard Keynes. Keynes economic theories emerged in response to the great depression that resulted in 25% unemployment.
Keynes classic economic work, The General Theory of Employment, Interest, and Money offered a new model arguing that a nation could slump into a state of stagnation and underemployment that could only be revived by increased government spending, even if it caused a large deficit. This spending would stimulate growth and get the economy back on track. Big spending became the magic elixir of the US government, culminating with Lyndon Johnson spending massively on both a war in Vietnam and a social security and work program at home. Government debt was in fashion.
There was a problem. Keynes theory had called for controlled spending once the economy was stimulated back on track. The US government missed this detail for 50 slowly leading up to a disaster with interest rates reaching 20% during Jimmy Carter’s presidency in the 1970s…until Ronald Regan arrived with the iron will to limit spending to income again. Regan’s formula was to stimulate economic growth through massive budget cuts and tax reductions…a full frontal attack on Keynesian economic theory. In Regan’s world, the economy was to benefit from unleashing productivity by allowing people and businesses to keep more of what they produced. The key was low taxes and less government regulation.
Interest Rates and the Economy
Another economic theory that has stood the test of time in its influence on the market is Irving Fisher’s interest rate theory. Fisher’s theories don’t make very entertaining reading, but in a nutshell, he shows that the level and volatility of interest rates, together with the terms and conditions of lending, are critical to corporate expansion and consumer spending. Together, these two components account for a large share of GDP. Fisher devised a formula that showed how inflation would lead to ballooning interest rates, and taxes just exacerbated the problem.
In sum, Fisher brilliantly showed that taxes and inflation are a nasty brew (no surprise, really…I never liked either one!). He clearly demonstrated how government policies that led to higher tax rates were a recipe for disaster, especially if market forces expect inflation to heat up. The reverse logic also held, that policies resulting in lower tax rates would calm credit markets and foster an improved interest rate environment.
So, when you see the stock markets all around the world holding their breath every time Alan Greenspan calls a meeting of the USA Federal Reserve Board to discuss interest rate policy, you know why.
Investors Focus Toward the Future
Most would agree that Alan Greenspan’s moves are of little impact on the markets. What really moves the market is investors perceptions of what Alan Greenspan will do. The markets always focus on the future, and reality is generally of less consequence than perceptions. By the time something actually happens, the market has already moved based on what all the participants thought would happen.
The same forward looking market moves result in stock indexes surging well ahead of an economic recovery as we saw in Singapore in late 1998. There was no concrete evidence of any recovery until early 1999, and no statistics to support a recovery until mid-1999. Economic indicators are historical in nature, while the markets are future oriented.
In summary, the markets move based on investor perceptions. These perceptions are based on best guesses about interest rate policies from governments. Interest rate and tax policies have a direct and intense affect on corporate profits and share prices. The short term market or share price movements can be mysterious and impossible to predict, while longer term movements will correlate well with economic drivers that lead to corporate profit performance. The market is always looking at least a year into the future.
