General Stock Market Index Performance is a Result of the Fed

The way that most people think about the stock market’s rising and falling is usually at odds with the economic reality. This is not entirely their fault; there is an academic consensus at play which reinforces the confusion, this consensus, of course, being the Keynesian paradigm. When the financial media talks about the stock market, the assumption is that, for instance, a stock market boom is the result of an economy that is healthy and progressing (profits are rising, companies are thriving, people are spending money) while a stock market bust is a result of the opposite underlying business conditions (profits are falling, companies are struggling, people are “hoarding” their money). This entire paradigm, while seemingly completely sound, is actually misleading.

When we consider consumer prices, it is easier for people (unless they are consciously viewing the world through a Keynesian lens) to recognize the fact that prices tend to fall as the economy grows. As the number of consumer goods rise due to the expansion of capital and production, the price tends to come down. This is supply and demand 101. This is why, during the most productive eras in United States history (the latter half of the 19th century) prices fell while people’s standard of living vastly improved. The supply of goods was expanding at a rate faster than the supply of money.

As Kel Kelly explains:

A progressing economy is one in which more goods are being produced over time. It is real “stuff,” not money per se, which represents real wealth. The more cars, 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 than money, prices will fall. With a constant supply of money, wages would remain the same while prices fell, because the supply of goods would increase while the supply of workers would not. But even when prices rise due to money being created faster than goods, prices still fall in real terms, because wages rise faster than prices. In either scenario, if productivity and output are increasing, goods get cheaper in real terms.

Obviously, then, a growing economy consists of prices falling, not rising. No matter 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).

The general or overall price level in the economy can only move up if A) everybody in the economy stops producing and saving (which is theoretical, but extremely unlikely that they would do this without some outside cause such as war or something); or if B) the amount of money in the economy increases faster than the amount of goods/services (which is historically exactly what happens).  In sum: the natural course of the free market is falling prices, but the natural course of an expansionary monetary policy is rising prices.

The same is true with stock market prices: the source of a large and continued increase in the general stock market price level is not increased productivity, but rather, more money flowing into the capital markets at large. For if the money supply was at a stand-still, the total price of all stock shares could not go up, mathematically. Yes, some shares would lose value, but this would take place as other shares gain value so that the sum total of the stock market was roughly the same year after year (of course, people could invest more and the market would go up microscopic amounts, or they could liquidate holdings and the market would tinker down, barely and theoretically— but we are talking about holistic and large stock market booms that take place at the beginning of the so-called “cycle.”).

In the case of a static money supply, stock indexes would tend to remain flat, and the only fluctuation that would take place wouldn’t be in the indexes holistically, but in the individual companies and their respective stocks. The very idea of “Modern Portfolio Theory” (MPT), which is that diversifying as much as possible over the long term provides the best return, presupposes the existence of a continued pipeline of newly created money. And the old school idea of “fundamental analysis” and “value investing” a la Benjamin Graham performs better in a situation in which the Fed is not manipulating the stock market via its monetary expansionism. This is why the difficulty in promoting value investing as a sympathizer of the Austrian School is present: because we live in a world in which the central banks pump money into “the economy” by way of the banking system. The result of the Federal Reserve system specifically is such that MPT looks like a great strategy while value investing is dismissed under the popular saying “don’t fight the Fed.”

The reality of the situation is that the only reason why MPT has appeared to be more successful is precisely because the Fed has destroyed the free market and propped up the equity markets. Under a free market, value investors would do better and have the opportunity “to beat the market” because the market itself would be flat. In this case, profiting via the stock market would be far more heavily focused on looking for dividend paying assets as companies pass on the profits to their owners: the stockholders. It is only under an inflationary regime that people’s nominal “wealth” can go up just by virtue of being a boat in a lake where water is constantly being pumped in.

Kel Kelly again:

Under these circumstances, capital gains (the profiting from the buying low and selling high of assets) could be made only by stock picking — by investing in companies 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 the average stock would not actually increase in value, most of the gains made by investors from stocks would be in the form of dividend payments. By contrast, in our world today, most stocks — good and bad ones — rise during inflationary bull markets and decline during bear markets. The good companies simply rise faster than the bad.

Booms and busts in the economy and in the stock market are the result of an increased supply of money and credit by way of the central bank’s monetary policy. The Fed “loosens” its policy and adjusts interest rates and creates new money, which then flows into assets; and then, responding to inflation, it “tightens” its policy. This is the source of booms and busts and holistic capital market movements. Rather than allowing the stock market’s role of price discovery to inform investors of which business are most effectively allocating resources, the Fed is effectively pushing up the general price level of the stock market to create the “wealth illusion” and give confidence to consumers that they can go out and spend. This encourages capital consumption, speculation, and a great era of resource misallocation that will certainly come back to bite us in the long run.

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