Does the Dow at 11,000 mean the economy is improving?
Written by Michael Vass
Recently we were asked by an associate
“If the economy is so bad, if the Stimulus is to blame, why is the stock market running higher?”
It’s a good question. Here is our answer.
The economy is in a bad place. The unemployment rate has yet to decrease below 9.5%, the underemployment rate is increasing, and tax hikes are looming. None of these factors bode well for the economy going forward either.
In 2010 the number of mortgages in trouble has increased, over the increases throughout 2009. Roughly 1 million homes are expected to be foreclosed on this year - likely even with the current hold on foreclosures. The housing market has yet to rebound in the face of this, and financial comapnies are still suffering as they try to absorb all the bad loans made.
The pressure on banks and other fiancial companies is restricting further loans. Given the outlook for continued unemployment in a range of 9.5 - 10.5% or greater until 2012, the fact that higher taxes means higher prices and thus lower consumer spending, and higher levels of foreclosures. Money is not flowing to the most needed area - smal businesses. This is true no matter how many Government loan stimuli are proposed or enacted or for whatever amount of billions, as most small businesses do not qualify especially in this environment.
That summary, which is given as very general, highlights the core of the problem. It is a problem that will not reverse overnight no matter what political party controls Congress. But it is a situation that can begin to improve depending on who is in Congress.
This is where the stock market comes into play.
Stocks do not move on news or fact. They move on the emotion created by news, facts, and rumor. That emotion often has little to do with anything but perception. And it is almost always a perception of the future.
Thus a company provides earnings that beat the street expectation and it moves higher based on the thought that it will continue to create bigger earnings. The counter is that if they miss the fear is that there is trouble and the company will not make estimates going forward.
An example is best seen in drug companies. The expectation of a drug being FDA approved can catapult a stock by hundreds of percent. Gaining FDA approval can rocket a stock based on the perception that enormous revenues will be earned. Neither is often true to the extent of emotion moving the stock. The counter is also true. AMLN missed FDA approval for the first drug in its pipeline, and the stock fell from about $12 to $6 in 3 minutes on the news. The company then eventually went to $.25 as the emotion was that the company would never get approval. Today the stock is at $21.41 a share after having gotten an FDA approval.
Looked at another way, the market has been in love with the earnings reports of many companies for several quarters now. Companies of every sort have outperformed expectations, and year over year results. This has moved many companies higher based on the outperformance. What is not being addressed is that the year over year comparisons are against some of the worst of quarters due to the mortgage/financial crisis and its aftermath. The reality is that a company just staying in business is highly likely to have shown better numbers just because they are still around. This is becoming less of a factor as business stabilizes a bit, though the emotion has yet to fizzle completely.
In addition to the above there is another factor. Politics.
The stock market tends to view politics in a very distinct manner. Historically it views elections as an indicator of how well they will do. Democrats tend to mean higher taxes and more regulation - thus restricting growth and depleting profits. Republicans are seen as the reverse.
So in looking at the overly simplified summary, the result is that the economy hasn’t gotten better. Companies have only improved the emotion that is felt about their stocks and future. Added to that is the emotional benefit from the growing consensus that a record-breaking return to a Republican-led Congress is impending. Emotions are running high, when that is positive the market runs, when it is not bears rake in cash.
Lastly, look at gold. As a barometer it tends to indicate how secure investors feel about the future. Low gold spot prices mean a positive economic outlook, stable is more of the same, and high means trouble on the horizon - as a general rule. Gold is currently $1348, and probably going to go higher near-term. At least until the issue of the Bush tax cuts and court questions on the Health Care Reform are resolved.
Taken in total, the Dow Jones Index is running because Democrats are about to lose power massively, and the expectation that there will be less tax and regulation in the future. The results for quarterly earnings is less a factor for now.
If all the outcomes are not exactly what is expected, investors will sell. If taxes are not lowered, if future earnings reports compared to non-devastation reports are flat to down, if Republicans do not control virtually every seat available in the election, if Health Care Reform is upheld by courts, and if further restrictive regulation is passed, the markets will reverse quickly.
As I have said back when I was a broker, don’t look at the market as a reflection of the health of the nation’s economy. Look to it as an indication of the emotion about the issues facing the nation next week.
