On Monday,
August 8, the S&P 500 stock-price index fell 6.7 percent to close at
1,119.46. The index fell 13.4 percent from July, and this was the fourth
consecutive monthly decline. It has fallen 17.9 percent from its high of
1,363.61 in April this year.
Also, the index's growth momentum
has fallen visibly. Year on year, the rate of growth declined to 6.7 percent
from 17.3 percent in July.
The trigger for the plunge in
stocks was Standard & Poor's lowering of the US Treasuries' rating from
AAA to AA+. But while the trigger may have been this downgrade, the key
factor that set in motion the plunge in stocks is the sharp deterioration in
the state of the pool of real savings as a result of loose monetary and
fiscal policies.
Normally, what matters for the
stock market is the state of monetary liquidity.
As economic activity slows down,
the demand for the services of the medium of exchange that money provides in
the real economy declines. Therefore, a surplus of money or an increase in
monetary liquidity emerges. As a rule this surplus is put to work in
financial markets, including the stock market. Consequently, the prices of
financial assets and stocks are pushed higher. (Remember, the price of an
item is the amount of dollars paid for the item. Likewise the price of a
stock is the amount of dollars paid per stock.)
For instance, the yearly rate of
growth of industrial production fell from 3.5 percent in January 1974 to
negative 12.4 percent in May 1975. The yearly rate of growth of the CPI fell
from 12.3 percent in December 1974 to 9.4 percent in June the following year.
Changes in the industrial production and the CPI can be seen as a proxy for
changes in the demand for money.
As a result, the yearly rate of
growth of surplus money climbed from negative 7.7 percent in March 1974 to
positive 7.6 percent in May 1975. In response to the increase in liquidity,
the S&P 500 climbed from 68.6 in December 1974 to 95.2 by June 1975
— an increase of 38.8 percent.
Historically, fluctuations in
liquidity precede fluctuations in the S&P 500 stock-price index (see
chart below).
For July this year, the growth
momentum of liquidity displays a visible uptrend — the yearly rate of
growth stood at 4.5 percent against 3 percent in June. So from a liquidity
perspective the S&P 500 appears to be well supported. What's more, there
is a growing likelihood that the Fed will embark on more money pumping.
So why then has the stock market
declined despite a strengthening in the growth momentum of monetary
liquidity? Most experts believe the reason is the S&P downgrade of US
government debt and a weakening in some key economic data. The yearly rate of
growth of real personal-consumption outlays fell to 1.8 percent in June from
2 percent in May. The ISM manufacturing index fell to 50.9 in July from 55.3
in June, while the ISM services index eased to 52.7 in July from 53.3 in the
previous month.
The growth momentum of real AMS
(the Austrian money supply[1] ) has been in an uptrend since April
last year. After closing at 0.8 percent in April last year, the yearly rate
of growth of real AMS jumped to 7.8 percent in July this year. (In June the
rate of growth stood at 6.4 percent.) The increase in the growth momentum of
real AMS should provide good support ahead for the ISM manufacturing and
services indexes (see charts below). All other things being equal, an uptrend
in the growth momentum of monetary liquidity coupled with a likely bounce in
the yearly rate of growth of key economic data should be good news for
stocks.
If the pool of real savings is in
trouble, then various key economic data will have difficulty performing well.
If the pool of real savings is falling, then an increase in liquidity is not
likely to be employed in the stock market. The state of the pool of real
savings dictates the economy's ability to generate wealth — that is,
economic growth.
For instance, the yearly rate of
growth of industrial production fell from 15.3 percent in January 1929 to
negative 24.6 percent in October 1930. The growth momentum of the
consumer-price index (CPI) also had a large fall during this period. The
yearly rate of growth fell from negative 1.2 percent in January 1929 to
negative 6.4 percent in December 1930.
In response to these large falls,
the yearly rate of growth of surplus money increased from negative 16.6
percent in May 1929 to a positive figure of 25.5 percent by November 1930.
Despite this strong increase in liquidity, the S&P 500 fell from 24.15 in
October 1929 to 15.34 by December 1930 — a fall of 36.5 percent. The
index in fact continued to slide falling to 4.4 by June 1932 — a fall
of 81.8 percent from October 1929.
The inability of the increase in
liquidity to affect the stock market from May 1929 to December 1930 was
because of a fall in the pool of real savings. The ensuing depression and
massive unemployment pushed people to stay out of any form of risky
investment for safety reasons.
We maintain that, regardless of the
downgrade by Standard & Poor's, if currently the percentage of
wealth-generating activities out of all activities is still above 50 percent,
then it is likely that the pool of real savings or the pool of funding is
still growing. Consequently, real economic growth should follow suit. In this
situation, the Fed could perpetuate the illusion that monetary pumping can
grow the economy. Indeed, in this situation an increase in the money supply's
rate of growth is likely to be associated with a rebound in various key
economic data and with a strengthening in the stock market.
If, however, less than 50 percent
of all activities are wealth generators, then more pumping will only make
things much worse. (Loose policies will only further weaken the pool of real
funding, deepen the economic slump, and deepen further the slide in stocks.)
Although we cannot quantify whether
the pool of real savings is currently expanding or stagnating, we can definitely
say that the loose policies of the Fed and the US government have weakened
the pool. The fact that, despite the aggressive pumping by the Fed (QE1 and
QE2), the economy remains depressed raises the possibility that perhaps the
pool of real funding is stagnant or worse. Obviously in this case, given the
fact that the Fed and the government will try to "revive" the
economy, the downtrend in the stock market could last much longer. (Such
policies will only undermine the pool of real funding further and delay
meaningful economic recovery.)
But what about the fact that
corporate earnings are doing very well? More than 75 percent of corporations
in the S&P 500 index have exceeded earnings estimates of Wall Street
analysts for the second quarter. Furthermore, most experts are of the view
that corporate earnings will rise by 18 percent in 2011 and 14 percent in
2012.
We suggest that, irrespective of
how supposedly well various companies are doing, if the pool of real funding
begins to slide the performance of so-called good companies will follow suit.
Conclusion
While Standard & Poor's
downgrade of US government debt has triggered the plunge in the stock market,
the underlying cause behind the stock market's sharp decline is loose
monetary and fiscal policies that have badly damaged the ability of the US
economy to generate wealth. Historically, fluctuations in monetary liquidity
have preceded fluctuations in the S&P 500 stock-price index. The recent
visible strengthening in the growth momentum of monetary liquidity will be of
little help to the stock market if the pool of real savings is stagnating or,
worse, declining.
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