By Rashi Mittal
Quite simply, there is a link between real economic activity and stock prices. But this link is sometimes tenuous, and it is just not true that when the economy is doing well; you can be sure that stocks will go up in an appropriate manner and vice verse. The problem is that the factors driving stock prices are just too complex, fragmented and contradictory for a simple “up and down” correlation to apply.
Factors driving the stock market-
Certainly, the business cycle does play a role. If you look at a chart of business cycle fluctuations, superimposed on a stock market index, you will see that the stock market generally and roughly follows. But generally and roughly are the operative words and that is the problem. If we consider some of the other factors that move the stock market besides the economic scenario, we can easily see how complex it all becomes.
- Interest Rates
If rates are likely to fall, stocks will be purchased and their prices will rise. But then there are also order quantities for American goods which push up stock prices when they increase and of course, the other way round. But foreign orders depend partly on exchange rates which also depend partly on the interest rate and so on.
- Investor Psychology
People may plunge into overheated markets which are best left alone. And they panic and flee at exactly the best time to buy. Throughout economic history we have seen how markets overshoot and push prices up to levels that are not justified by the real economy. And there is the converse with people selling out more than what the economic situation justifies; simply because sentiment is negative.
- Political Factors and Sundry Disasters
An election, an assassination, a terrorists attacks, a epidemics of diseases and many other shocks that can appear tomorrow and vanish the next day; or be around for the next 20 years can either help you make or lose your money. Note that these are non-economic factors, meaning that the stock market reflects these too.
Additionally, some of these factors are inevitably driving share prices up, while others are pushing them down; sometimes the same variable can have contradictory results when measured against other variables. So we have a simultaneous and
multifaceted interaction of forces working in all directions with extremely variable and varied intensities.
Apart from the hard and soft factors described above, a fundamental reason for buying stocks is simply that people think other buyers will pay more for them in the future. This is the essence of speculation and clearly has little to do with the productive process at the heart of economic development.
Where does this leave us?
Stock prices are driven by a very messy combination of economic, psychological and political fundamentals. The result is that it is impossible to know in advance which “fundamentals” and “non-fundamentals” will really prevail. Despite all this, the trend can still be your friend. It is often possible to figure out which factors will dominate over time and in particular over a given period of time. Likewise, some stocks, sectors and asset classes that look good in themselves, are really worth having. Predictions are possible and it is not all a game of chance. But, if you are looking for sure-fire indicators and think that the business cycle and the stock exchange cycle are one and the same, you will be in for a disappointment or worse.
The trick is not to try and figure out all the angles, but to determine what factors are likely to count most over the time span of the investment. Despite the multitude of influences that are potentially relevant, some are more important than others at certain times and for certain assets.
In conclusion, if the economy is performing well, the stock market is likely to do the same. But, there is no real reliable and consistent link that persists through all-market cycles in a predictable pattern. There are simply too many forces at work and economic reality is just one of them. This does not mean that anything can happen, but it does mean that the financial sector and the real sector go hand in hand only part of the time and part of the way. This process is well summed-up by one expert as being similar to a dog (the stock market) going for a walk with its master (the real economy). The dog often runs this way and that often in an unpredictable matter. But it will come back to its master – until the next walk.
Views presented in the article are those of the author and not of ED.