Curious Capitalist

How Long Can the Stock Market Defy Economic Gravity?

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As the pragmatic conservative economist Herbert Stein once said, “If something cannot go on forever, it won’t.” I’ve been thinking about that saying a lot in relation to today’s bull market and the complacency with which investors seem to view it.

The VIX, or fear index—which measures investors’ expectations of volatility in the stock market—is at its lowest ebb since 2007, before the financial crisis. Prices for all sorts of assets, even things like junk bonds, are soaring in a way that would seem to indicate blue skies over the global economy. All this despite the fact that we’re still facing the debt ceiling debate, the resolution of the Eurozone crisis, and a real estate bubble in China that could make the Middle Kingdom go “pop.”

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Part of the bullishness may be a reaction to the fact that things have been tough in the global economy for so long, investors believe they can’t get tougher. But it also reflects history. According to Ruchir Sharma, the head of emerging markets and global macroeconomics for Morgan Stanley Investment Management, who has examined the past 100 years of bull-market history, we’re exactly where we ought to be in the economic cycle. Typically, by the fourth year of a recovery, stocks have more than doubled. In the fifth year, markets tend to rise about 10%, which is what many analysts predict for this year. In this context, the low fear index and bullish sentiment seem perfectly reasonable.

But there’s a problem: While markets are reacting just as history tells us they should, the real economy is not. Putting aside a better-than-expected fourth quarter last year, we are still in the middle of the second weakest recovery in a century and the weakest one of the post–World War II era. McKinsey Global Institute estimates that it will take another 25 months for employment to reach prerecession levels.

Just as worrisome is the disconnect between the fortunes of companies and the fortunes of workers, which has never been greater. Stock prices are far from a perfect proxy for the economy; they ultimately reflect the earnings and earnings potential of large corporations. While 60% of the profits of the S&P 500 today come from large multinational manufacturing firms, those companies account for only about 15% of U.S. employment, far less than when outsourcing to nations with cheaper labor costs began on a large scale in the 1980s. Many of these companies get an increasing share of their sales from abroad, some of them as much as half, while wages paid to U.S. workers remain flat.

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Put these facts together and it’s clear that global gains for American multinationals are no guarantee of economic growth and job creation at home. This is an important—and often overlooked— risk factor in the markets right now. At some point, as Sharma puts it, “you need stronger growth in the real economy for corporate earnings to go up.” We may already be at a breaking point. For more on that, check out my Curious Capitalist column in the latest issue of TIME magazine.

5 comments
Walterdirtmagician
Walterdirtmagician

It will not go on forever, the question is not if but when, and there are many better indicators that the value of the market of the real economy.  I for one do not have nor will I ever invest another dime in the market which in my opinion is so overvalued it brings to mind fantasy.  What I find most amazing other than the stock market is the artificially low interest rates, it too will end, it it will not be fun to at last pay the piper his due for this "free" ride. The squirrel knows what happens to you when you do stash enough nuts away for the cold season, we have forgotten because it has made sense to put some away, the nuts have been plentiful in more ways than one

JohnDavidDeatherage
JohnDavidDeatherage

The stock market (currently) doesn't reflect the health of the economy. The market reflects the growth in the money supply as a result of Quantitative Easings programs 1, 2, 3, 4 and ?. 

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