The Surprising Reason Why Stock Prices Matter to the Economy

With a week or so left in 2021, it is still possible that the stock market will deliver a Santa Claus rally. But smart investors should be thinking about what may follow any short-term burst in stocks.

In this article, I will explore a little recognized relationship between stocks and the economy and why it matters.

How Inflation Emerged This Year

There is no denying it, from the gas pump to the grocery store, everything costs more than a few months ago.

So, what’s the root cause? One word: inflation.

Think of inflation in terms of supply. When there is too much of one thing and not enough of another, prices rise. Specifically, we now have too much money in circulation and not enough things to buy, which leads to higher prices.

Sure, most of us don’t feel like we have too much money in our pockets. But the fact is that due to the COVID pandemic, the Federal Reserve was forced to increase the amount of money in circulation.

And yes, little of this money came to you or me directly, as it went to banks and other lending institutions, such as mortgage lenders. That’s because to increase the amount of money in circulation, central banks buy bonds from institutional bond holders, not you or me.

But here is where it gets interesting. Aside from the central bank’s actions, the U.S. government, and other governments around the world also increased the money supply via stimulus checks, extended employment benefits, childhood credits, loan forgiveness programs, and in the case of the U.S. the Paycheck Protection Program (PPP), which lent businesses money so they could keep their operations going during the pandemic.

Meanwhile, the global economy ground to a halt. And while much of the economy has bounced back, there is still plenty of slack in the system. That’s because people, through retirement, illness, death from COVID, and maybe just because they decided to drop out of society, just never came back to work, which has kept many factories idle or working at less than full capacity.

As a result, there is too much money available and not enough production to meet demand for goods and services.

And that is the classic definition of inflation.

Nothing New Under the Sun

Anyone who was alive in the 1970s, as I was, remembers that over a few years, gasoline went from 19 cents per gallon (yes, it’s true) to well over a dollar in a relatively short period of time. And along with gasoline so did everything else to the tune where the U.S. inflation rate was at or near 10% for an extended period of time.

As a result, the Federal Reserve, under then-Chairman Paul Volcker, embarked on a multi-year rate hike cycle, culminating with a Federal funds rate which at its peak in 1981 was 20%. It certainly worked, most of the time, until 2020.

Why This Time Is Different

Unfortunately, this time is different, as the amount of money in circulation is well beyond any historical precedent, and because the global financial system is completely different than at any time in history.

That’s because, unlike in the 1970s, whereby the Glass-Steagall Act separated bank financial assets from depositor cash, it’s all one big pool of money now.

Accordingly, in the 1970s and 1980s, when Wall Street crashed, Main Street tended to hold up a bit better. But now, there is no firewall between speculative money and mom and dad’s money.

The net effect is that the stock market has gained control of the economy. As a result, we now have what I call the MELA system: M is for the markets, E is for the economy, L is for people’s life and financial decisions, and A is for the way artificial intelligence (AI, algos) affects the flow of information.

Look at it this way:

  • More people than ever depend on trading and retirement plans such as 401ks and Individual Retirement Accounts (IRAs) for financial support and spending money.
  • Higher stock prices make people feel wealthy.
  • People that feel wealthy spend money and the economy prospers.
  • Algos speed up information and transactions so people make decisions faster and the economy grows faster.

How Things Could Unravel

In March 2020, stocks fell 36% in six weeks as the COVID pandemic unfolded. This market decline combined with a global economic shutdown led to a de facto depression, which eventually led to global central banks creating record amounts of money into thin air.

This was bullish for stocks, increasing people’s feeling of well being and the economy recovered.

But the Fed and many investors are still under the impression that the economy influences the markets.

It doesn’t. It’s the other way around.

And what that means is that if the stock market breaks down again, the economy will surely follow, just as it did in 2020.

Read This Story: Markets at Year-End: Naughty or Nice?

So if the Santa rally does come, enjoy it, because when the Fed makes its move to hike rates, conditions could change in a hurry.

In the meantime, are you looking for a trading methodology that provides big gains but also mitigates current risks? Click here for details.