Stock prices, in theory, reflect the present value of all future profits. Although no one can consistently predict future profits, everyone can try. Shifts in the expectations of profits — both short-term and long-term — then get translated into stock prices. If the economy grows more slowly than in the past, business profits will presumably also grow more slowly. Once investors realize this, stock prices will fall to reflect the darker outlook.
The mechanism works in both directions. If profit expectations improve, so should stock prices. One drama of the Trump era is the quarrel between the administration (which insists that its tax cuts and regulatory policies will raise economic growth and profits) and some of its critics (who believe that an economic growth slowdown is unavoidable). Slipping stock prices may vindicate the critics.
Pertinent to the debate is a new study by economists at the International Monetary Fund (IMF). They argue that recessions and economic crises leave “scars” that lead to permanent losses in production and income. Their hypothesis is not just a hunch. They studied recessions and economic crises in 190 countries — both advanced and developing nations — between 1974 and 2012. The negative effect on their economies varied between 5 percent and 15 percent of output, depending on the type of setback. Economic growth usually resumes but from a smaller base.
This finding contradicts the conventional wisdom about business cycles, say IMF economists Valerie Cerra and Sweta C. Saxena. The common view, they contend, holds that deep recessions are followed by strong recoveries that make up the ground lost during the slump. The fact that this doesn’t usually happen — but is believed to occur — may explain why many recent economic forecasts (including those of the IMF, the Obama administration, the Federal Reserve and many private economists) have been unduly optimistic.
Just what “scars” weaken economic recoveries, the paper doesn’t say. But the usual suspects are no secret: heavy debt burdens by businesses, governments and households that inhibit spending; greater risk aversion by companies that slows hiring and investing; more caution by consumers in shopping. There’s a danger of a “vicious circle of low investment, consumption, hiring and innovating,” Cerra and Saxena said in an email.
There are other trends working in the same direction. Growth of the working population is slowing as baby boomers retire. Productivity gains have similarly diminished. Both changes weaken the economy.
It’s true that Cerra and Saxena don’t apply their theory to the stock market. Their focus is on the nature of the business cycle. Still, their analysis — if corroborated by others — has obvious implications for stocks. If recessions and economic crises permanently damage the economy, then the consequences will, sooner or later, show up in stock prices.
Whatever the cause, the euphoria of the Trump stock market seems to be dissipating. This could weaken the real economy of production and jobs as private investors — feeling poorer — curb their spending.
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