The Booming Market Strengthens the Case for Stimulus
The second half of that answer is correct in a literal sense. But it would be wrong to say that the market is not an important part of the economy, or that the signals it sends should be ignored. Most truly serious changes in the economy are reflected in financial markets — and vice versa.
Stock market indices and the standard measure of the economy, gross domestic product, are two lenses on the same phenomenon. GDP is a measure of the real flow of goods and services produced in a given year. The markets, in theory at least, are a measure of the present value of the future return to (corporate) capital.
To understand how these two measures relate to each other, it’s necessary to see how they relate to a third: gross domestic income, or GDI, which is the sum of all wages, profits, interests and rents collected in a given year. GDI and GDP, theoretically at least, are the same. And GDI is related to market indices because a predictable component of it consists of profits — corporate profits in particular.
The P in GDP — production — can be hard to define. Think of a contractor who bought a couple cans of paint at Home Depot last year and uses them to paint a house this year. Do both the paint and the painted house count as production in their respective years?
The somewhat complicated answer: When the contractor buys the paint, Home Depot records the sale and it's added to GDP. When the contractor uses the paint, they count it as a cost and it is subtracted from GDP.
This method essentially calculates economic production the way businesses calculate an income statement. Production is the value of output created minus inputs used — regardless of when or where the inputs themselves were created.
Thus, GDP and GDI are two measures of the same thing. One tallies the products firms create; the other counts the income they receive. But they’re both measuring the size of the economy. Over time, the two measures always find their way back to each other.
That said, on a quarterly basis growth in GDP and GDI can look markedly different. This quarter-to-quarter variation between GDP and GDI is one reason why attempts to correlate movements in stock indices and movements in GDP tend to be disappointing. There is simply a lot of noise in the quarterly statistics.
The close link between GDI and GDP, in turn, shows why there is a relationship between GDP growth and stock indices. Corporate profits are a component of GDI. And while their share of GDI fluctuates, it typically hovers between 20% and 25% — rising when the economy is growing rapidly and falling when it is growing slowly.
What this all means is that high and rising corporate profits presage stronger economic growth, while collapsing corporate profits predict weaker growth. That’s the link between the economy and the market.
That’s all well and good, you might say, but don’t stock prices often run wildly ahead of profits? And doesn’t this distort whatever signal the market might be sending?
The short answers are yes and no. Shares can fluctuate wildly, a phenomenon that economists call excess volatility, or momentum. Yet it is precisely the volatile nature of stock prices, which can seem so irrational to the general public, that makes them so valuable as an economic signal. Stock prices make sharper moves than profits, and profits make sharper moves than the overall economy. Over time, however, they are all aligned.
Keep in mind, however, that two-word caveat: over time. At any given moment, stock prices and GDP may be out of sync, which is why it’s a mistake to overreact to market moves.
All of which brings us back to President Joe Biden’s $1.9 trillion stimulus package. The passage of a fourth relief bill late last year, combined with Democratic control of the White House and Congress, has created strong conditions for rapid economic growth. More spending is almost certainly on the way, but with moderate Democrats calling the shots, the chances for sharp increases in taxes or the minimum wage are less likely.
It’s natural to expect the markets, being a hyper-reactive measure of future economic conditions, to get ahead themselves on such of fortuitous and unusual set of circumstances. For the same reason, it would be wrong to see booming markets as a reason not to pass more Covid relief.
Soaring equity prices aren’t themselves evidence of a booming economy. But they’re a serious sign that the U.S. is on the right track. It would be foolish to ignore that signal and switch tracks now.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.
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