The Stock Market Is Telling Everyone The Fed Has It Wrong
The stock market is designed to serve as more than a mechanism for trading stocks. In theory, it is an efficient aggregator of current information and future expectations about each company, the national economy, and the world economy. Stock prices should reflect the present value of the stream of future expected corporate earnings where future earnings are discounted based on expectations of future inflation rates.
According to this theory, essentially the theory for which the University of Chicago's Eugene Fama just won a share of the Nobel Prize in Economics, good news about the economy should make most stock prices rise and bad news should cause the stocks of most companies to fall. Yet, what we have seen for months is the opposite and the reason for this perverse stock market behavior is the Federal Reserve policy of Quantitative Easing.
In complete opposition to the normal behavior of the stock market, for months now bad economic news has been good for stock prices. When job growth is below expectations, the market goes up. When GDP growth is slow, the market goes up. Bad news for a specific company pushes that company's stock down, but bad news in the aggregate makes the stock market rise overall.
The counterintuitive action extends to good news. Higher job growth is met by market declines. Strong corporate profits lead to lower stock prices. When the stock market should go up, it goes down. When logic demands it go down, it goes up. The answer to this bizarre market behavior is simple: the stock market is being ruled by the Fed, not by fundamentals.
The market is backward because bad news is understood to mean that the Federal Reserve will continue pumping money into the economy through its Quantitative Easing program. Good news is bad for the market because it makes people worry that QE3 may come to an end. In simple terms, what matters to the stock market is the easy money from the Fed, not the performance of the companies whose stocks they are buying and selling.
The Federal Reserve has two goals for its policies: to keep interest rates low and to increase the amount of money available for lending. The Fed thinks this will lead to economic growth but all it has really accomplished is to boost the stock market.
Cheap money made available by the Fed's policies mean that large investors (hedge funds, institutional investors, money center banks) can borrow huge sums of money at very low interest rates, invest it in the stock market, and profit by the difference in returns. The Fed's policies also mean that millions of individual, small investors have been driven out of certificates of deposit and other fixed income investments into the stock market in search of decent returns.
The Fed's actions have depressed interest rates to such a low level that the stock market has become the only investment game in town.
The manner in which the stock market indices slide on any hint that the Fed's easy money policies may be approaching an end show that the Fed is artificially inflating the stock market. Clearly, the stock market's boost from the Fed is not permanent as the market has made clear it will drop as soon as the Fed turns off the pump.
To the extent that the Fed has a proper role in supporting economic growth, it should be pursuing policies that create actual economic growth: increased production and the associated employment gains. Stock market gains are not economic growth. Surely the Keynesians running the Fed are not boosting the stock market so that the wealth gains of the large investors and banks can trickle down to the rest of the population.
The vast majority of investments in the stock market have nothing to do with economic growth. Public offerings (initial or secondary) serve to funnel money from investors to companies for use in growing their business. This is a beneficial role for stock markets. However, secondary trading, with one investor buying as another sells, does nothing to create jobs or increase production. It is simply a change in the ownership of a company, and even that is only at a very small scale usually with no impact at all on the actual running of the business.
If the Fed actually wanted to foster economic growth it would stop the Quantitative Easing and let interest rates rise to where the free market decides. Then savers could earn a reasonable return on their savings, boosting incomes for many seniors and likely supporting increases in consumer spending. There might be a sharp adjustment in the stock markets, but then perhaps fundamentals will return and the stock market will go back to acting like it should. Banks and other large investors would look for actual projects to invest in rather than simply playing the stock market.
The action of the stock markets, moving in opposite directions from economic news, is a clear signal that the Fed has distorted the stock market to the extent where only the Fed's action matters. The Fed should recognize this as a strong hint it has gone too far and surpassed the bounds of simply helping to support the economy. Worse, the Fed's policies are actually hurting the economy by diverting resources from productive uses into stock investments. With less "help" from the Fed, things would get better.