Why is the stock market doing well when the economy is doing badly?

Readers question: Why is the stock market peaking when the economy is doing badly?

There is an old saying that the stock market has predicted 10 out of the last three recessions. Similarly, you could argue the stock market has been predicting several recent economic recoveries which haven’t really materialised.

FTSE_100_Index

How to explain why  the stock market is doing well in the current recession?

  • The stock market is always looking forward to the next one or two years. There is hope that the economy will finally be emerging from the current recession. Economic recovery will see a growth in the profits of firms and lead to better dividends. This makes investors optimistic to buy shares now in anticipation of future economic recovery and growing dividends.
  • In particular, global stock markets are responding to recovery in the US. It is the Dow Jones that is pulling up other stock markets, and the FTSE-100 is benefiting from this improvement in US prospects. For example, better than expected job news in US is improving confidence, and markets are hopeful that the recent recovery will be maintained. (Stock markets seem confident the US won’t self destruct with premature fiscal tightening.)
  • The stock market is recovering lost ground – it is recovering a level last reached in 1999 during the mid point of the great moderation.This helps puts the recent surge in context.  If you had invested money in the stock market in 2000 – you would have received a poor return over the past 12-13 years. If you’d bought at the end of 2008, you would have done well in past few years. You would have got a much better return from buying a house in 2000.
  • Many companies have been increasing their cash reserves in the recession. They have been holding back from investing and improving their cash reserves. e.g. in US cash reserves increased from 8% of assets to 12% of assets in 2009. (link) The improved cash reserves makes firms more attractive as an investment.
  • Quantitative easing has led to an increase in cash for investment trusts and banks. The Bank of England’s policy of quantitative easing has involved purchasing £375bn of assets – mostly government bonds. This has left banks and investment trusts with more cash. Some of this has found itself into the stock markets. With bond yields falling because of quantitative easing, it makes stocks relatively more attractive. This highlights the unequal nature of quantitative easing. The benefits have fallen mainly to the city and commercial banks. This explains why there is more funds for shares – despite continued economic weakness and falling real wages. (see: who benefits from quantitative easing)

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