Are buoyant stock markets a sign of financial trouble ahead?

I have written before about how well many stock market indices have performed, notwithstanding the pandemic. That good performance has continued, with the US S&P 500 reaching record levels last week. This is puzzling, and might be a sign of a crisis in the making.

What is clear is that few, if any, of the world’s economies are going to shake the crisis off quickly. A rapid partial recovery from the depths of the lockdown is more than plausible, but it is hard to see things getting all the way back to normal. Consumer demand, the main driver of modern economies, looks to be dented for the long term, as many of the public, older people in particular, remain cautious, even if most lockdown restrictions are completely lifted – which they won’t be. You can take a horse to water, but you cannot make it drink. And, of course, a lot businesses are going to fail because of the lockdown, meaning that a lot of people will be put out of work. Meanwhile many businesses and public agencies will suffer a significant loss in productivity as safety measures continue to be in operation. While that might benefit jobs, it implies reduced living standards too, which will also make it hard for businesses to bounce back. The prospect of a vaccine being universally available is distant. The whole world cannot eliminate the virus like New Zealand has done, at the expense of cutting itself off from the rest of the world.

So if the economy is unable to bounce back to where it was in December 2019, why are stocks doing so well, after they fell so far earlier in the year? The obvious answer is that investors have taken leave of their senses, falling for optimistic stories peddled outside the mainstream media. Well I have seen such craziness take hold, back in the late 1990s with the tech boom, but this does not look like it. There must be a more rational explanation. I can think of two, and neither are good news.

The first is that not all companies’ share prices are doing well, and the rise in well-publicised indices is based on large companies who are expected to do well out of the crisis. Companies like Amazon, Microsoft or Alphabet (i.e. Google). When businesses fail, others benefit. The crisis will provide stronger companies with opportunities. The stock market indices are not a representative cross-section of businesses in the economy, but a collection of the bigger ones. But for this to justify such a high level of price gain, it means that investors think these businesses will be able to take advantage of their market dominance to raise prices. In other words, the wreckage left behind by the crisis will lead to widespread price-gouging, which will benefit the companies represented in the indices. This would be bad news because it means that yet another dent in productivity that will reduce living standards of everybody except the lucky. I don’t think this is very likely, but it is plausible that this is what many investors think will happen. There would be parallels with the tech boom of the 1990s if so.

The second possible explanation for high stock prices is an idea I have read in quite a few commentaries. It is that investors “have nowhere else to go” except to put money into shares. In other words, there is a savings glut, and the alternatives to shares look a worse prospect. There is plenty of reason to think that there is a savings glut. Many people are saving more as a result of the crisis, because there are fewer opportunities to spend, while incomes are being propped up by government support schemes. Meanwhile businesses, with a few exceptions like pharmaceutical companies, are cutting investment due to uncertainty. More saving plus reduced investment means a glut. And many people have suggested the world economy has been stuck in a chronic savings glut for the last couple of decades anyway.

The main alternative investment to shares, if you are are looking for a home for trillions rather than mere billions of dollars, is bonds. But interest rates on public debt have been cut to minimal, even negative, levels as part of the monetary response to the crisis. This means almost no prospect of a positive return either from interest payments or capital gains (which would require interest rates to fall even further). Some private companies have bonds offering higher yields (i.e. ratio of interest to price), but that is because of a higher risk of default. These do not look an attractive prospect in the current environment.

Which leaves either keeping the money uninvested in bank accounts, or investing in shares. A lot of people are keeping their money in cash, but this suffers a similar problem to bonds: low interest and no capital gain. Which leaves shares, whose price then rises because demand exceeds supply. That does not necessarily mean that shares offer a better return in the long run. Most investment decisions are not made by people for their own money, but by middle men such as investment managers. They need a good story rather than a sober assessment to justify their decisions. One advantage of shares is that it is very easy to spin a story, and picking crisis winners, as well talking up a rebound, might be just such stories.

But the savings glut explanation is bad news. It is not a stable situation because it implies that demand is being sucked out of the economy. This is one of the standard principles of Economics that is taught in undergraduates’ first year (the so-called Economics 101). It is what caused economic depressions before the economist Maynard Keynes showed that governments could offset this with deficit spending. Governments are indulging in deficit spending to an extent that is unprecedented in peacetime, but the rise in stock markets seems to be showing that they are not doing enough, or rather that their interventions are being parked in savings rather than spent.

How might this play out? The financial system is under a high level of stress. Levels of private and public debt are very high in most of the major economies. Private debt is the most likely breaking point, both in terms of bond default and bank bad debts. This vulnerability plays out in different ways in different countries, but the USA, the EU and China all look vulnerable this time in their different ways. Britain has its own vulnerabilities too, with a high current account deficit, a badly managed epidemic and full departure from the EU about to impact later in the year. This could then lead to a more widespread financial calamity.

The Great Financial Crisis of 2008-2009 was preceded by over a year of unreality, when the nature of the crisis was exposed, but markets were in a sort of stunned disbelief. It was like a supersaturated solution waiting for speck of dust to start a mass crystallisation: the Lehman Brothers collapse was the speck of dust. I was scared enough in 2007 to move my pension fund into index-linked government stock – so I’m not using hindsight here. The situation now is different, but I think the same sort of unreality is present. This will be a very different crisis if it comes.

I don’t think that most countries will suffer a 1930s style depression. Governments will have to intervene big, but they can and look ready to do so, though this will be more complicated in the EU. My prediction is that this will not just take the form of measures to stimulate demand, but interventions to keep businesses going.A lot of wealth will be destroyed. It will be a great moment to be a socialist.

Have I finally succumbed to cabin-fever? I have noticed more than one columnist I respect going a bit off the rails (look at Matthew Parris in The Times this weekend). I will have to leave that to you to judge!

6 thoughts on “Are buoyant stock markets a sign of financial trouble ahead?”

  1. @ Matthew,

    I think you’re probably right in that, paradoxically, a rise in share value reflects a problem rather than a fundamental positive outlook of the economy. As you say, there is nowhere else to go. Even before the Pandemic there was an underlying problem.

    As interest rates have fallen it has made sense, in the short term, for those bigger companies who can borrow cheaply to use the money to buy back their own shares which pushes up their value. As the price has risen other buyers are drawn into the market too. So there’s probably a bubble but who knows how long it will last?

    As someone famous once said, the market can remain irrational for longer than most of us can remain solvent! So I’m not offering any share advice. Having said that I did advise my wife to sell some unit trusts just before the Covid crisis started and that worked out well. I really shouldn’t do that though! I’d have never have heard the end of it if they had risen.

    I’d just make the point that putting money into shares, rather like buying houses, doesn’t soak up any savings. For every buyer there is a seller who has to do something with the money. This will contribute to keeping up aggregate demand in the short term. But just as there can be terrible consequences, on a macroeconomic level, when a housing bubble bursts, so there can when the same happens in the stock market.

    1. Yes good point about the fact that buying shares (or property) does not of itself take money out of circulation. I guess the only way it can do is if the money is ultimately used to pay off bank loans and overdrafts, which causes the money supply to shrink, if I have understood it correctly. There is no evidence that that is happening on a large scale.Apparently there is some issuance of new equity, so some of the money is going to companies rather than the investors merry go round, but there seems to be no surge of real investment. These are uncharted waters.

  2. Yes, paying off loans and overdrafts is essentially saving. Anyone with a mortgage, for example, is usually better off paying that back more quickly rather than putting spare money into a savings account.

    I don’t like the term “money supply”. Money can exist and be totally inert. Like if I have a stash of high value bank notes in a safe. That is starting to be a more sensible option as interest rates head into negative territory. So how does the rest of the economy know they are there? And react to their existence accordingly?

    Money is ultimately either spent on goods and services or it is saved. Both of these have an effect. A third possibility could be exchanged in a financial transaction for assets like shares or, say, a valuable antique or painting. This is economically neutral. The decision on whatever was going to be done with the money is transferred from buyer to seller.

    1. I think you are right on the term “money supply”. Such economic concepts are part physical quantities and part guesses about human behaviour. By itself the fact that there a large amount of money around doesn’t tell you very much. Just as the issue now isn’t a lack of income, but the fact that people aren’t spending it (plus the complication of supplying them if they did…)

  3. Occam’s razor. The simple answer to the buoyant stock markets
    The stock market will continue to bubble along with price of shares firm and rising?/ For it is the job of those of those working in that sector to, keep on Keeping On. Their wages their bonus’s depend on it “When the music stops, in terms of liquidity, things will be complicated,” Chuck Prince of Citigroup said prior to the crash in 2008. “But as long as the music is playing, you’ve got to get up and dance.”
    In none of these companies are people ready to point out that the Emperor has no clothes, who wants to be the harbinger of doom , No personal mileage in that

    1. Yes that quote from Chuck Prince remains me of that year of unreality before the crash actually happened.

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