It’s Time To Look At America’s Two Economies

Today, when you open the business section of your newspaper or watch financial news on television, it is obvious that we have moved from an entrepreneurial economy toward a very centrally planned economy. Fiscal and monetary policies have become almost an obsession. Politicians and pundits have convinced most people that the government can and should solve any problems we have. And as you know, politics drives fiscal and monetary policy. Therefore, it is important that each of us have a longer-term understanding and outlook of the economy; and it must be as non-partisan as humanly possible.

Following is my view. This view may differ from yours because my assumption is that the economy and markets do not work, except on a very long-term basis, the way most people think they should.

First, we need to put the real economy (not just the political economy we read about every day) into context so we can distinguish the actual economy from the artificial, centrally planned economy. This makes it possible to see the two economies. Once you understand both, you will be in a position to develop a short-term plan for your business and your investments; and a longer-term plan for when these two economies collide.

Most people think that when the economy (GDP) grows, corporate profits grow which causes stock prices to increase. This is true if you are thinking very long-term. But what really causes the economy to grow is when the government increases the money supply (prints money.)

GDP growth, by definition, is only possible if you increase the money supply. If the money supply did not increase, you would have a fixed number of dollars in the economy. Therefore, increased spending in one area of the economy would cause a decline in another area with net, aggregate growth of zero.

If the definition of economic growth was more wealth, rather than more money, the economy could certainly grow if GDP stays at zero. Think about how technology has increased our wealth over the years at the same time that prices were are being consistently reduced.

However, the problem with increasing the money supply is:

1.It decreases the value of the dollar, reducing buying power, which then causes inflation.
2.It causes malinvestments (investments go into marginally productive ventures that cannot sustain themselves once interest rates rise or when credit or money is withdrawn from the financial system.) It can/does cause bubbles.
3.It reduces the ability of productive companies to obtain the capital they need) long-term) crowding out real productive ventures.

Current fiscal and monetary policy

The Federal Reserve Bank, using a government (Keynesian) periscope, has decided that we are not de-leveraging (bringing prices back to equilibrium); we are instead close to falling into deflation. This Keynesian definition means a chronic slowing of consumer spending or demand. It is not the original or traditional definition of deflation which is a contraction of the money supply.) Therefore, the Fed is expected to soon (maybe in November) begin the second round of quantitative easing (printing money.)

Therefore, to increase consumer demand, the Fed plans to hold interest rates artificially low and pump money into the banking system to incentivise the consumer. This, plus continuous stimulus programs and overspending tax collections have not worked to date. Some of the reasons are:

1.Banks have over $1 trillion in excess reserves but are not lending (for several reasons) so credit expansion is not occurring which is necessary to hype demand
2.We have had over $900 billion in stimulus programs plus $2.7 trillion in “additional” government spending over the past two years. GDP has risen by about $800 billion over the same two-year period.
3.A lot of this money has found its way into emerging countries in the form of investments. Two emerging countries have started to tax foreign investment funds in order to slow down their growth.

Conclusion

Government (fiscal and monetary) policy cannot continue down this same path much longer without it causing horrendous inflation. Our debt and committed future obligations already exceed 100% of current, tax collections for many decades into the future.

Plus, we still have many significant economic problems before the economy can really begin to grow including the financial system, housing, over-levered consumers, unemployment, states and municipalities in serious deficits and asking the federal government to bail them out (estimates are around $300 billion now) and many more.

Therefore, unless there is a clear change in government policy (by both political parties,) it appears that additional stimulus, low interest rates and excessive printing of money will continue. Since money supply is the initial driver of our economy, the GDP number may stay positive and above water. But, this printing and spending money plus low interest rates will require investors to make significant changes in all asset classes.

Does The Economy Drive The Stock Market?

What drives the capital markets? Is it the economy or something else? The short answer of course is the economy, but only over the long term. There is much more to it than a simple, if A then B.

I recently read an excellent article by Kel Kelly (writer and former trader)who ties the business cycle into the relationship between the economy and the markets. I thought I would share my interpretation of some of his thoughts with you. This will take several articles but I think you will get a better understanding of the relationship between the market and the economy.

If you listen to the pundits and the media, you get the impression that capital markets are driven by things like:

1. Psychology or crowd behavior or “animal spirits”,consumer sentiment or
2. Technological analysis or patterns of behavior (charts), instant correlations or
3. Data points like corporate earnings or expected earnings, revenues or
4. Marginal economic data points like consumer spending, interest rates, GDP growth, increasing or decreasing labor costs, etc.

In the real world, the most common view is that the economy drives the markets. As the economy (GDP) grows, corporate revenues and profits grow. This growth increases profits and the value of the company, which is then reflected in the stock price. The reverse is also true; if the growth rate of the economy declines, profits are reduced and stock prices fall.

While this view is basically correct, over the long term; you could have a difficult time predicting where the market is headed in the short-term. I looked at the quarterly, rate of change in the economy and the S&P500 over the past ten years. The correlation for the two is 0.40. Not that strong a relationship.

Yet, most economists and pundits today use at-the-margin data points (for example, a monthly turn in the data, a two or three month trend, etc.) to predict the future direction of the economy. This is a backward looking view of the economy not a forward-looking view. Plus, they are always waiting for the next data point rather than making a definitive decision. By the way, you have to stay tuned for tomorrow’s new, backward-looking data.

Can you remember the last time one of these projections was correct? Just to add a little humor into this, how about the National Bureau of Economic Research’s ruling a few weeks ago, after 18 months of rigorous analysis, that the current recession ended in March of 2009.

Real force driving the stock market

Over the next few articles, I hope to show that the real force driving the market, over the longer term, is changes in the quantity of money and the volume of spending in the economy. This precedes the rise in GDP (economy.) In other words, capital markets rise when the money supply is inflated and stocks fall when the money supply contracts (note: they can fall for other reasons as well.)