Curious Capitalist

Why the S&P 500 Is Defying Economic Reality

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The markets hold many mysteries, and here’s a big one: Why the heck is the S&P 500, up 14% this year, behaving as though we’re living large when nearly every piece of real economic data is depressing?

Europe is imploding. China is still growing but slowing. Manufacturing is down worldwide, as are exports. In the U.S., the workforce hasn’t been this small relative to the population since 1981. Moody’s is threatening (again) to downgrade our credit rating if Congress can’t avoid the fiscal cliff next year.

While it’s absolutely true that economic fundamentals don’t support bullish markets, it’s also true that stocks aren’t behaving irrationally. So, how to square the two facts?

(MORE: Will the Stock Market Keep on Rising?)

The Occam’s razor explanation is that U.S. stocks, as well as T-bills, are simply the nicest houses in the ugly neighborhood that is the global economy. “This year, for the first time since 2007, it’s likely that U.S. growth is going to outperform global growth,” notes Ruchir Sharma, head of emerging markets and global macro-economics for Morgan Stanley Investment Management. We think the 2% economy is terrible; in Europe, it would be a gift.

Investors may also be raising their bets on an Obama re-election—the S&P rises in line with prediction markets’ views on his chances—and thus more stimulus. The bottom line is that the year-to-date performance of U.S. equities has surpassed everything from gold to oil to bonds to any kind of emerging-market stocks.

That’s exactly what Bernanke wanted, and in fact, the Fed chairman helped create that outcome with asset purchases (known as quantitative easing, or QE) and very low interest rates. The idea is that low rates drive up asset prices; higher asset prices make people feel richer; this “wealth effect” prompts people to spend; and that spending prompts companies to invest and create jobs to meet rising demand. Or so the theory goes.

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Unfortunately, not everyone owns stocks, and the richest 10% of the U.S. population owns 75% of them. So to the extent that anyone feels richer, it’s mostly those who already were rich — and you can’t stage a true economic revival with only 10% of the country spending. There’s also the problem of the $2 trillion in corporate cash under the mattress. Just as QE has not sparked a private spending boom, it also has yet to ignite a large-scale corporate one.

To find out more about why that is, and whether the Fed can still do anything about it, check out my latest Curious Capitalist column in TIME magazine.