How the Stockmarket and Economy Really Work

8/8/2019 How the Stockmarket and Economy Really Work

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How the Stock Market and Economy Really Work By Kel Kelly – Mises Daily

"A growing economy consists of prices falling, not rising."

The stock market does not work the way most people think. A commonly heldbelief — on Main Street as well as on Wall Street — is that a stock-market boomis the reflection of a progressing economy: as the economy improves, companiesmake more money, and their stock value rises in accordance with the increase intheir intrinsic value. A major assumption underlying this belief is that consumerconfidence and consequent consumer spending are drivers of economic growth.

A stock-market bust, on the other hand, is held to result from a drop in consumerand business confidence and spending — due to inflation, rising oil prices, highinterest rates, etc., or for no reason at all — that leads to declining businessprofits and rising unemployment. Whatever the supposed cause, in the commonview a weakening economy results in falling company revenues and lower-than-expected future earnings, resulting in falling intrinsic values and falling stockprices.

This understanding of bull and bear markets, while held by academics,investment professionals, and individual investors alike, is technically correct ifviewed superficially but is substantially misconceived because it is based onfaulty finance and economic theory.

In fact, the only real force that ultimately makes the stock market or any market

rise (and, to a large extent, fall) over the longer term is simply changes in thequantity of money and the volume of spending in the economy. Stocks rise whenthere is inflation of the money supply (i.e., more money in the economy and inthe markets). This truth has many consequences that should be considered.

Since stock markets can fall — and fall often — to various degrees for numerousreasons (including a decline in the quantity of money and spending), our focushere will be only on why they are able to rise in a sustained fashion over thelonger term.

The Fundamental Source of All Rising Prices

For perspective, let's put stock prices aside for a moment and make sure first tounderstand how aggregate consumer prices rise. In short, overall prices can riseonly if the quantity of money in the economy increases faster than the quantity ofgoods and services. (In economically retrogressing countries, prices can risewhen the supply of goods diminishes while the supply of money remains thesame, or even rises.)



When the supply of goods and services rises faster than the supply of money —as happened during most of the 1800s — the unit price of each good or servicefalls, since a given supply of money has to buy, or "cover," an increasing supplyof goods or services. George Reisman offers us the critical formula for thederivation of economy-wide prices:[1]

In this formula, price (P) is determined by demand (D) divided by supply (S). Theformula shows us that it is mathematically impossible for aggregate prices to riseby any means other than (1) increasing demand, or (2) decreasing supply; i.e.,by either more money being spent to buy goods, or fewer goods being sold in theeconomy.

In our developed economy, the supply of goods is not decreasing, or at least notat enough of a pace to raise prices at the usual rate of 3–4 percent per year;prices are rising due to more money entering the marketplace.

The same price formula noted above can equally be applied to asset prices —stocks, bonds, commodities, houses, oil, fine art, etc. It also pertains to corporaterevenues and profits. As Fritz Machlup states:

It is impossible for the profits of all or of the majority of enterprises to rise withoutan increase in the effective monetary circulation (through the creation of newcredit or dishoarding).[2]

To return to our focus on the stock market in particular, it should be seen nowthat the market cannot continually rise on a sustained basis without more money

— specifically bank credit — flowing into it.

There are other ways the market could go higher, but their effects are temporary.For example, an increase in net savings involving less money spent on consumergoods and more invested in the stock market (resulting in lower prices ofconsumer goods) could send stock prices higher, but only by the specific extentof the new savings, assuming all of it is redirected to the stock market.

The same applies to reduced tax rates. These would be temporary effectsresulting in a finite and terminal increase in stock prices. Money coming off the"sidelines" could also lift the market, but once all sideline money was inserted

into the market, there would be no more funds with which to bid prices higher.The only source of ongoing fuel that could propel the market — any asset market — higher is new and additional bank credit. As Machlup writes,

If it were not for the elasticity of bank credit … a boom in security values couldnot last for any length of time. In the absence of inflationary credit the fundsavailable for lending to the public for security purchases would soon be



exhausted, since even a large supply is ultimately limited. The supply of fundsderived solely from current new savings and current amortization allowances isfairly inelastic.… Only if the credit organization of the banks (by means ofinflationary credit) or large-scale dishoarding by the public make the supply ofloanable funds highly elastic, can a lasting boom develop.… A rise on the

securities market cannot last any length of time unless the public is both willingand able to make increased purchases.[3] (Emphasis added.)

The last line in the quote helps to reveal that neither population growth norconsumer sentiment alone can drive stock prices higher. Whatever thepopulation, it is using a finite quantity of money; whatever the sentiment, it mustbe accompanied by the public's ability to add additional funds to the market inorder to drive it higher.[4]

Understanding that the flow of recently created money is the driving force ofrising asset markets has numerous implications. The rest of this article

addresses some of these implications.

The Link between the Economy and the Stock Market

The primary link between the stock market and the economy — in the aggregate — is that an increase in money and credit pushes up both GDP and the stockmarket simultaneously.

A progressing economy is one in which more goods are being produced overtime. It is real "stuff," not money per se, which represents real wealth. The morecars, refrigerators, food, clothes, medicines, and hammocks we have, the better

off our lives. We saw above that, if goods are produced at a faster rate thanmoney, prices will fall. With a constant supply of money, wages would remain thesame while prices fell, because the supply of goods would increase while thesupply of workers would not. But even when prices rise due to money beingcreated faster than goods, prices still fall in real terms , because wages rise fasterthan prices. In either scenario, if productivity and output are increasing, goodsget cheaper in real terms.

Obviously, then, a growing economy consists of prices falling, not rising. Nomatter how many goods are produced, if the quantity of money remains constant,the only money that can be spent in an economy is the particular amount of

money existing in it (and velocity, or the number of times each dollar is spent,could not change very much if the money supply remained unchanged).

This alone reveals that GDP does not necessarily tell us much about the numberof actual goods and services being produced; it only tells us that if (even real)GDP is rising, the money supply must be increasing, since a rise in GDP ismathematically possible only if the money price of individual goods produced is



increasing to some degree.[5] Otherwise, with a constant supply of money andspending, the total amount of money companies earn — the total selling prices ofall goods produced — and thus GDP itself would all necessarily remain constantyear after year.

"Consider that if our rate of inflation were high enough, used cars would rise inprice just like new cars, only at a slower rate."

The same concept would apply to the stock market: if there were a constantamount of money in the economy, the sum total of all shares of all stocks takentogether (or a stock index) could not increase. Plus, if company profits, in theaggregate, were not increasing, there would be no aggregate increase inearnings per share to be imputed into stock prices.

In an economy where the quantity of money was static, the levels of stockindexes, year by year, would stay approximately even, or drift slightly lower[6] —

depending on the rate of increase in the number of new shares issued. And,overall, businesses (in the aggregate) would be selling a greater volume of goodsat lower prices, and total revenues would remain the same. In the same way,businesses, overall, would purchase more goods at lower prices each year,keeping the spread between costs and revenues about the same, which wouldkeep aggregate profits about the same.

Under these circumstances, capital gains (the profiting from the buying low andselling high of assets) could be made only by stock picking — by investing incompanies that are expanding market share, bringing to market new products,etc., thus truly gaining proportionately more revenues and profits at the expense

of those companies that are less innovative and efficient.

The stock prices of the gaining companies would rise while others fell. Since theaverage stock would not actually increase in value, most of the gains made byinvestors from stocks would be in the form of dividend payments. By contrast, inour world today, most stocks — good and bad ones — rise during inflationary bullmarkets and decline during bear markets. The good companies simply rise fasterthan the bad.

Similarly, housing prices under static money would actually fall slowly — unlesstheir value was significantly increased by renovations and remodeling. Older

houses would sell for much less than newer houses. To put this in perspective,consider that if our rate of inflation were high enough, used cars would rise inprice just like new cars, only at a slower rate — but just about everything wouldincrease in price, as it does in countries with hyperinflation The amount by whicha home "increases in value" over 30 years really just represents the amount ofpurchasing power that the dollars we hold have lost: while the dollars lostpurchasing power, the house — and other assets more limited in supply growth

— kept its purchasing power.



Since we have seen that neither the stock market nor GDP can rise on asustained basis without more money pushing them higher, we can now clearlyunderstand that an improving economy neither consists of an increasing GDPnor does it cause the overall stock market to rise.

This is not to say that a link does not exist between the money that companiesearn and their value on the stock exchange in our inflationary world today, butthat the parameters of that link — valuation relationships such as earnings ratiosand stock-market capitalization as a percent of GDP — are rather flexible, and aswe will see below, change over time. Money sometimes flows more into stocksand at other times more into the underlying companies, changing the balance ofthe valuation relationships.

Forced Investing

As we have seen, the whole concept of rising asset prices and stock investmentsconstantly increasing in value is an economic illusion. What we are really seeing

is our currency being devalued by the addition of new currency issued by thecentral bank. The prices of stocks, houses, gold, etc., do not really rise; theymerely do better at keeping their value than do paper bills and digital checkingaccounts, since their supply is not increasing as fast as are paper bills and digitalchecking accounts.

"An improving economy neither consists of an increasing GDP nor does it causethe overall stock market to rise."The fact that we have to save for the future is, in fact, an outrage. Were nomoney printed by the government and the banks, things would get cheaperthrough time, and we would not need much money for retirement, because itwould cost much less to live each day then than it does now. But we are forcedto invest in today's government-manipulated inflation-creation world in order to tryto keep our purchasing power constant.

To the extent that some of us even come close to succeeding, we are stillpushed further behind by having our "gains" taxed. The whole system of inflationis solely for the purpose of theft and wealth redistribution. In a world absent ofgovernment printing presses and wealth taxes, the armies of investmentadvisors, pension-fund administrators, estate planners, lawyers, and accountantsassociated with helping us plan for the future would mostly not exist. Thesepeople would instead be employed in other industries producing goods andservices that would truly increase our standards of living.

The Fundamentals are Not the Fundamentals

If it is, then, primarily newly printed money flowing into and pushing up the pricesof stocks and other assets, what real importance do the so-called fundamentals

— revenues, earnings, cash flow, etc. — have? In the case of the fundamentals,



too, it is newly printed money from the central bank, for the most part, thatimpacts these variables in the aggregate: the financial fundamentals aredetermined to a large degree by economic changes.

For example, revenues and, particularly, profits, rise and fall with the ebb and

flow of money and spending that arises from central-bank credit creation. Whenthe government creates new money and inserts it into the economy, the newmoney increases sales revenues of companies before it increases their costs;when sales revenues rise faster than costs, profit margins increase.

Specifically, how this comes about is that new money, created electronically bythe government and loaned out through banks, is spent by borrowingcompanies.[7] Their expenditures show up as new and additional sales revenuesfor businesses. But much of the corresponding costs associated with the newrevenues lags behind in time because of technical accounting procedures, suchas the spreading of asset costs across the useful life of the asset (depreciation)

and the postponing of recognition of inventory costs until the product is sold (costof goods sold). These practices delay the recognition of costs on the profit-and-nloss statements (i.e., income statements).

Since these costs are recognized on companies' income statements months oryears after they are actually incurred, their monetary value is diminished byinflation by the time they are recognized. For example, if a company recognizes$1 million in costs for equipment purchased in 1999, that $1 million is worth lesstoday than in 1999; but on the income statement the corresponding revenuesrecognized today are in today's purchasing power. Therefore, there is anequivalently greater amount of revenues spent today for the same items than

there was ten years ago (since it takes more money to buy the same good, dueto the devaluation of the currency).

"With more money being created through time, the amount of revenues is alwaysgreater than the amount of costs, since most costs are incurred when there isless money existing."Another way of looking at it is that, with more money being created through time,the amount of revenues is always greater than the amount of costs, since mostcosts are incurred when there is less money existing. Thus, because of inflation,the total monetary value of business costs in a given time frame is smaller thanthe total monetary value of the corresponding business revenues. Were there no

inflation, costs would more closely equal revenues, even if their recognition weredelayed.

In summary, credit expansion increases the spreads between revenue and costs,increasing profit margins. The tremendous amount of money created in 2008 and2009 is what is responsible for the fantastic profits companies are currentlyreporting (even though the amount of money loaned out was small, relative to theincrease in the monetary base).



Since business sales revenues increase before business costs, with every roundof new money printed, business profit margins stay widened; they also increasein line with an increased rate of inflation. This is one reason why countries withhigh rates of inflation have such high rates of profit.[8] During bad economictimes, when the government has quit printing money at a high rate, profits shrink,

and during times of deflation, sales revenues fall faster than do costs.

It is also new money flowing into industry from the central bank that is theprimary cause behind positive changes in leading economic indicators such asindustrial production, consumer durables spending, and retail sales. As newmoney is created, these variables rise based on the new monetary demand, notbecause of resumed real economic growth.

A final example of money affecting the fundamentals is interest rates. It is saidthat when interest rates fall, the common method of discounting future expectedcash flows with market interest rates means that the stock market should rise,

since future earnings should be valued more highly. This is true both logicallyand mathematically. But, in the aggregate, if there is no more money with whichto bid up stock prices, it is difficult for prices to rise, unless the interest ratedeclined due to an increase in savings rates.

In reality, the help needed to lift the market comes from the fact that wheninterest rates are lowered, it is by way of the central bank creating new moneythat hits the loanable-funds markets. This increases the supply of loanable fundsand thus lowers rates. It is this new money being inserted into the market thatthen helps propel it higher.

(I would personally argue that most of the discounting of future values [PVcalculations] demonstrated in finance textbooks and undertaken on Wall Streetare misconceived as well. In a world of a constant money supply and fallingprices, the future monetary value of the income of the average company wouldbe about the same as the present value. Future values would hardly need to bediscounted for time preference [and mathematically, it would not make sense],since lower consumer prices in the future would address this. Though investmentanalysts believe they should discount future values, I believe that they shouldnot. What they should instead be discounting is earnings inflation and assetinflation, each of which grows at different paces.)[9]

Asset Inflation versus Consumer Price Inflation

Newly printed money can affect asset prices more than consumer prices. Mostpeople think that the Federal Reserve has done a good job of preventing inflationover the last twenty-plus years. The reality is that it has created a tremendousamount of money, but that the money has disproportionately flowed into financialmarkets instead of into the real economy, where it would have otherwise createddrastically more price inflation.



There are two main reasons for this channeling of money into financial assets.The first is changes in the financial system in the mid and late 1980s, when anexplosive growth of domestic credit channels outside of traditional bank lendingopened up in the financial markets. The second is changes in the US trade deficitin the late 1980s, wherein it became larger, and export receipts received by

foreigners were increasingly recycled by foreign central banks into US assetmarkets.[10] As financial economist Peter Warburton states,

a diversification of the credit process has shifted the centre of gravity away fromconventional bank lending. The ascendancy of financial markets and theproliferation of domestic credit channels outside the [traditional] monetary systemhave greatly diminished the linkages between … credit expansion and priceinflation in the large western economies. The impressive reduction of inflation is adangerous illusion; it has been obtained largely by substituting one set of seriousproblems for another.[11]

And, as bond-fund guru Bill Gross said,

What now appears to be confirmed as a housing bubble, was substantiallyinflated by nearly $1 trillion of annual reserve flowing back into US Treasury andmortgage markets at subsidized yields.… This foreign repatriation producedartificially low yields.… There is likely near unanimity that it is now responsible forpumping nearly $800 billion of cash flow into our bond and equity marketsannually.[12]

This insight into the explanation for a lack of price inflation in recent decadesshould also show that the massive amount of reserves the Fed created in 2008

and 2009 — in response to the recession — might not lead to quite the wildconsumer-price inflation everyone expects when it eventually leaves the bankingsystem but instead to wild asset price inflation.

One effect of the new money flowing disproportionately into asset prices is thatthe Fed cannot "grow the economy" as much as it used to, since more of the newmoney created in the banking system flows into asset prices rather than intoGDP. Since it is commonly thought that creating money is necessary for agrowing economy, and since it is believed that the Fed creates real demand(instead of only monetary demand), the Fed pumps more and more money intothe economy in order to "grow it."

That also means that more money — relative to the size of the economy —"leaks" out into asset prices than used to be the case. The result is not onlyexploding asset prices in the United States, such as the NASDAQ and housing-market bubbles but also in other countries throughout the world, as new moneymakes its way into asset markets of foreign countries.[13]



A second effect of more new money being channeled into asset prices is, ashinted above, that it results in the traditional range of stock valuations moving toa higher level. For example, the ratio of stock prices to stock earnings (P/E ratio)now averages about 20, whereas it used to average 10–15. It now bottoms out ata level of 12–16 instead of the historical 5. A similar elevated state applies to

Tobin's Q, a measure of the market value of a company's stock relative to itsbook value. But the change in relative flow of new money to asset prices inrecent years is perhaps best seen in the chart below, which shows the stunningincrease in total stock-market capitalization as a percentage of GDP (figure 1).

Figure 1: The Size of the Stock Market Relative to GDPSource: Thechartstore.comThe changes in these valuation indicators I have shown above reveal that thefundamental links between company earnings and their stock-market valuationcan be altered merely by money flows originating from the central bank.

Can Government Spending Revive the Stock Market and the Economy?The answer is yes and no. Government spending does not restore any realdemand, only nominal monetary demand. Monetary demand is completelyunrelated to the real economy, i.e., real production, the creation of goods andservices, the rise in real wages, and the ability to consume real things — asopposed to a calculated GDP number.

Government spending harms the economy and forestalls its healing. The thoughtthat stimulus spending, i.e., taking money from the productive sector (a de-accumulation of capital) and using it to consume existing consumer goods orusing it to direct capital goods toward unprofitable uses, could in turn create newnet real wealth — real goods and services — is preposterous.

What is most needed during recessions is for the economy to be allowed to getworse — for it to flush out the excesses and reset itself on firm footing. Brokeneconomies suffer from a misallocation of resources consequent upon priorgovernment interventions and can therefore be healed only by allowing theeconomy's natural balance to be restored. Falling prices and lack of governmentand consumer spending are part of this process.

Given that government spending cannot help the real economy, can it help the

specific indicator called GDP? Yes it can. Since GDP is mostly a measure ofinflation, if banks are willing to lend and lenders are willing to borrow, then thenewly created money that the government is spending will make its way throughthe economy. As banks lend the new money once they receive it, the moneymultiplier will kick in and the money supply will increase, which will raise GDP.



"What is most needed during recessions is for the economy to be allowed to getworse — for it to flush out the excesses and reset itself on firm footing."

As for the idea that government spending helps the stock market, the analysis isa bit more complicated. Government spending per se cannot help the stock

market, since little, if any, of the money spent will find its way into financialmarkets. But the creation of money that occurs when the central bank (indirectly)purchases new government debt can certainly raise the stock market. If newmoney created by the central bank is loaned out through banks, much of it willend up in the stock market and other financial markets, pushing prices higher.

Summary

The most important economic and financial indicator in today's inflationary worldis money supply. Trying to anticipate stock-market and GDP movements byanalyzing traditional economic and financial indicators can lead to incorrectforecasts. To rely on these "fundamentals" is to largely ignore the specific

economic forces that most significantly affect those same fundamentals — mostnotably the changes in the money supply. Therefore, following monetaryindicators would be the best insight into future stock prices and GDP growth.

Kel Kelly has spent over 13 years as a Wall Street trader, a corporate financeanalyst, and a research director for a Fortune 500 management consulting firm.Results of his financial analyses have been presented on CNBC Europe, and theonline editions of CNN, Forbes , BusinessWeek , and the Wall Street Journal . Kelholds a degree in economics from the University of Tennessee, an MBA from theUniversity of Hartford, and an MS in economics from Florida State University. Helives in Atlanta.

Notes

[1] See G. Reisman, Capitalism: A Treatise on Economics (1996), p.897, for afuller demonstration. Most of the insights in this paper are derived from the high-level principles laid out by Reisman. For additional related insights on this topic,see Reisman, "The Stock Market, Profits, and Credit Expansion," "The Anatomyof Deflation," and "Monetary Reform."

[2] F. Machlup, The Stock Market, Credit, and Capital Formation (1940), p. 90.

[3] Ibid., pp. 92, 78.

[4] For a holistic view in simple mathematical terms of how the price of all items in an economy may or may not rise, depending on the quantity of money, see K.Kelly, The Case for Legalizing Capitalism (2010), pp 132–133.



[5] Price increases are supposedly adjusted for, but "deflators" don't fully deflate.Proof of this is the very fact that even though rising prices have allegedly beenaccounted for by a price deflator, prices still rise (real GDP still increases).Without an increase in the quantity of money, such a rise would bemathematically impossible.

[6] To gain an understanding of earning interest (dividends in this case) whileprices fall, see Thorsten Polleit's "Free Money Against 'Inflation Bias'."

[7] Most funds are borrowed from banks for the purpose of business investment;only a small amount is borrowed for the purpose of consumption. Even borrowingfor long-term consumer consumption, such as for housing or automobiles, is aminority of total borrowing from banks.

[8] The other main reason for this, if the country is poor, is the fact that there is alack of capital: the more capital, the lower the rate of profit will be, and vice versa

(though it can never go to zero).

[9]Any reader who is interested in exploring and poking holes in this theory withme should feel free to contact me to discuss.

[10]This recycling is what Mises's friend, the French economist Jacques Reuff,called "a childish game in which, after each round, winners return their marbles tothe losers" (as cited by Richard Duncan, The Dollar Crisis (2003), p. 23).

[11] P. Warburton, Debt and Delusion: Central Bank Follies that Threaten

Economic Disaster (2005), p. 35.

[12] William H. Gross, "100 Bottles of Beer on the Wall."

[13] It's not actually American dollars (both paper bills and bank accounts) thatmake their way around the world, as most dollars must remain in the UnitedStates. But for most dollars received by foreign exporters, foreign central bankscreate additional local currency in order to maintain exchange rates. This newforeign currency — along with more whose creation stems from "coordinated"monetary policies between countries — pushes up asset prices in foreigncountries in unison with domestic asset prices.

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How the Stockmarket and Economy Really Work