Does the stock market make sense? Many question the record highs to which the Dow Jones Industrial Average has been bounding in March 2013 when compared with the state of the US economy. Just how can stocks be doing so well when unemployment continues to drag, when the country continues to bear such a huge deficit, sequestration is about to take effect and Washington appears to be in gridlock?
Is it a case of “irrational exuberance” a condition cited by former Fed Chief Alan Greenspan during the dot.com bubble? Is the market irrational, unpredictable and totally detached from the economy (and reality)?
“Two staggering drunks connected by a long rope”
Perhaps the idea of the market’s unpredictability can be best seen in the example provided by UCLA Professor Roger Farmer in “Bloomberg Businessweek.” He equates the relationship between the stock market and the economy as that of “two staggering drunks connected by a long rope.” Sometimes they move in unison, other times they each take their own path. Ultimately, however, the rope never lets them stray too far from each other. Each is rational and predictable and, ultimately, intertwined, even if not moving in lockstep.
Strange, but not unpredictable
Or in the words of former Citibank CEO John Reed, “Markets are strange.” However, they aren’t necessarily irrational or unpredictable. When one begins looking at just what businesses make up the stock market today, one sees myriad companies that are sitting on piles of cash (post-recession).
Many of the events in Washington and abroad (in Europe, in particular) have made those companies reluctant to take measures to hire new employees or plunge their resources into new product development. The world has been full of uncertainty that has made US companies behave cautiously, not irrationally.
The richest company listed on the stock exchange, Apple (NASDAQ: AAPL), has so much money (some $137 billion according to “Forbes” magazine), in fact, that investors like David Einhorn are so mad that they are suing the company to either use it or return those profits to its shareholders. Likewise for the banking companies, who have shored up their accounts in the face of more stringent regulations and tightening credit requirements for their borrowers.
Behavior of investors
The actions of investors are not lacking in predictability either. In fact, according to “Bloomberg Businessweek,” “Market rallies can be self-perpetuating.”
The higher the price of stocks climb, the more they want to buy, unlike products like gasoline or movie tickets. “John Maynard Keynes observed, the stock market is like a beauty contest in which your own opinion doesn’t matter; you pick the face that you think others will choose,” noted “Businessweek.”
Stock prices have continued to rise based on sound fundamentals and cash-rich balance sheets. Investors are behaving predictably given what’s on offer. Whether the stock market will continue its exuberance may be less predictable, given that it is in part dependent upon US fiscal policy, which lies with the US Congress and Executive Branch.
Overall, given the knowable forces at work today, the stock market is behaving predictably, as are investors.