The daily stock market story is always good for a few laughs. Market analysts excel as phrase makers and instant experts. For the market's every twitch, they have an answer. But the answers usually are about as illuminating as the daily horoscope.
If, for example, the market declines, it's because the economy is advancing too rapidly, inflation is increasing and the trade deficit is rising. Or, it's because the economy is advancing too slowly, consumer confidence is slipping and profits seem uncertain.
On the other hand, if the market is up, it's because the economy is advancing rapidly and profits will rise. Or, it's because the economy is advancing slowly and inflation will subside. Then, again, it may be that today's real news wasn't quite as bad as yesterday's anticipated news. Or, if nothing else fits, the market experienced a "technical correction."
The plain truth is that Monday morning quarterbacking is cheap and confusing, and the market baffles most people - stock analysts, businessmen and economists alike. The sharp decline of the past 16 months has seemed especially mysterious, raising two questions. Why have prices dropped? And does the drop affect the "real" economy: do consumers and business - feeling poorer - spend less?
The genuinely perplexing aspect of the market slide is its coincidence with a rise in profits. Traditionally, bigger profits push stock prices higher, and there's no doubt that profits have increased. In 1977, after-tax profits increased from $63.3 billion to $70.7 billion. Dividends rose from $35.8 billion to $41.2 billion. Meanwhile, the New York Stock Exchange index slumped about 10 percent, from 57.88 to 42.50. In this index, 1965 prices are 50, which indicates just how dispirited the market is. In 1978, this and other indexes have dropped even further.
The obvious explanation for this apparent paradox is that market psychology has changed. And, in fact, this may be precisely what's happened. According to a recent analysis by Martin Neil Baily, a professor of economics at Yale University, changes in profits simply don't excite investors as much as they did 20 to 25 years ago. Rather, investors watch inflation and interest rates.
In his analysis (in the latest issue of the Brookings Papers on Economic Activity), Baily found that changes in profits and changes in stock prices tended to move together between 1948 and 1961. Investors, he reasoned, viewed rising profits as a sign of a healthy business expansion that would mean still higher future profits. In the 1960s, the relationship weakened and, by the 1970s, virtually disappeared.
Instead, investors' preoccupation with inflation, Baily speculated, indicated their belief that inflation would now mean anti-inflation measures later - and, therefore, a slowdown or recession accompanied by lower profits. Likewise, higher inflation tends to push up interest rates and makes stocks a less attractive investment compared with bonds.
If investors do think this way, then the market slide of the past year is not so bizarre. In 1977, consumer prices rose 6.9 percent (against 6.1 percent in 1976). Although many economists still estimate the "underlying" inflation rate at 6 percent, a minority now thinks that the rate may be closer to 7 percent. Similarly, short-term interest rates rose two percentage points last year.
Assuming the stock market is inflation sensitive, an even more intriguing question is whether a slumping market tends to be a self-fulfilling prophecy, discouraging business and consumers from spending.
A number of economists think it is. Depending on prices, stocks account for about one-sixth to one-fourth of the net worth of individuals: that is, their assets (such as homes and stocks) minus their liabilities (mortgages and other loans).
Frederic Mishkin, a professor of economics at the University of Chicago, argues that a market decline makes consumers feel threatened and induces them to cut back spending. In 1974-75, Mishkin says, as much as 40 percent of the recession stemmed from consumers' loss of wealth, heavily influenced by the stock market's fall.
Investment is said to follow a somewhat similar pattern. Corporations won't make large new investments if a dollar of investment in tangible assets - plant and equipment - isn't worth a dollar in stock prices. To do so (it's argued) simply would be wasting shareholders' money: taking a dollar on Tuesday and translating it into 80 cents on Wednesday. For, in fact, the prices of stocks don't equal new investment costs. At the end indicate that a slowdown in inflation would pay a sizable dividend in added growth for the economy. The stock market would rise, and both consumers and businesses would spend more. And, by this reasoning, today's stagnant market would foreshadow a stagnant economy.
By implication, these theories of 1977, the ratio was about 80 percent.
It sounds simple. In fact, however, many (possibly most) economists don't believe the real world works this way. They don't think the market accurately forecasts booms and busts, and they don't think that business or consumer spending relates so directly to market fluctuations. In making long-term investments, for example, executives may look primarily at profit potential and the need for new capacity.
As for the market's effect on consumer spending, two qualifications leave the issue in doubt. First, the same factors - higher incomes or lower inflation, for example - may push up both consumer spending and the stock market at the same time. Second, stock ownership is heavily concerntrated among wealthy and upper-middle-class groups, raising questions about the impact on spending. In 1972, for example, the top 1 percent of the population was estimated to hold about 56 percent of personal stock wealth. However, these upper classes also account for a disproportionate share of spending.
So the market remains an enigma. It is probably neither as unimportant as some economists pretend nor as critical as some businessmen believe. But it is a crude barometer of confidence. The market and the economy can be at odds for brief periods, but over the long run, they reflect one another. And, right now, one or the other is emitting false signals.