Stock market “optimism” in a stagnant era

Every attempt to read the tea leaves about our economic future runs into the relatively upbeat stock market – the one minty-fresh leaf in an otherwise bitter brew.  The workforce is crashing, several quarters of nearly flatline GDP growth are predicted, the economy trembles in fear of the next thousand pages of regulations that ObamaCare will excrete… and yet the stock market looks pretty good, with a few reversals here and there.  Naturally, optimists seize on the stock market as the indicator we should pay the most attention to.  Investors seem to think the “recovery” is finally under way, don’t they?

Not so fast, says Jerry Bowyer of Forbes, who has written a remarkably clear and concise treatise about how to interpret the allegedly “optimistic” stock market as yet another indicator of stagnant growth to come.  The key is to consider the stock market in relation to the bond market.  As Bowyer explains:

Stocks by themselves might be showing some signs of optimism about growth (or at least monetary easing), but the equity market is not the whole market. Yes, when stock prices go up, that can often be a sign of optimism, but not when bond prices have gone up more. In other words, at the risk of oversimplifying: when investors are buying more stocks than bonds they expect growth. On the other hand when markets are buying more bonds than stocks (as they did in response to this week’s lousy March jobs report), they expect stagnation or even contraction.

He backs this up with a good deal of charts and data, explaining that stocks are relatively risky but high-yield investments, while bonds are relatively safe but low-yield.  In a time of economic stagnation, investors demand relatively high yield on those risky stock investments, and pump a lot of money into safe bonds.  That appears to be what is happening now.

Computing a value called the “equity risk premium” that measures “the amount by which the generally riskier equity yield exceeds the less risky bond yield,” Bowyer finds this metric currently floating near its historical high of 5 percent, which tracks very closely with periods of weak economic growth.

No economic forecasting model can lay claim to perfect accuracy, and of course even the best model cannot incorporate unanticipated developments.  Most of the “known unknowns” in our near future are negative factors – conflict on the Korean peninsula or in the Middle East, the disintegration of the Eurozone, China’s weakening economy – but there might always be some happy “unknown unknowns,” such as the development of some invigorating new technologies.

It is, however, difficult to look at current indicators and believe a great “recovery” is finally in progress.  Happy days are not here again, and unfortunately the policies that would give us a shot at real recovery were swept off the table with the re-election of Barack Obama.  The one seemingly anomalous bit of sunny data, the performance of the stock market, really isn’t all that anomalous or sunny at all.


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