Where Is the US Stock Market Heading?
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 supply1) 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.
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.