Saturday, April 18, 2009

The optimistic bear

Consider the following headline: US STOCKS-Economic optimism, GE spur 6th week run-up

The link between "economic optimism" and stock prices is somewhat tenuous. Of course, stock prices increase when the probability of economic recovery increases unexpectedly, as cyclical recoveries are good for corporate profitability. However, this is where the link ends. There are many circumstances where economic growth would not necessarily translate into higher profits accruing to shareholders of existing firms:

- High rates of growth in developing economies resulting from relatively high savings rates coupled with the reallocation of labour away from agriculture.

- Higher rates of growth in developed and developing economies resulting from capital infusion into new firms.

- Higher rates of growth resulting from technological change in a competitive economy (where the benefits would flow to consumers, and the suppliers of labour).

There is also a distributional story to tell in regards to the link between stock prices and "economic optimism". The recent significant declines in stock prices and housing prices in many parts of the world are not good news for shareholders of existing firms or owners of the existing housing stock, but (assuming the declines were not entirely driven by "fundamentals") will benefit those individuals who are considering purchasing a stake in the economy's capital and housing stock, as they will see a better rates of return on funds invested.

Therefore, it is important not to generalise the link between optimism and stock prices beyond the obvious cyclical channel.

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