Economic Commentary – The Stock Market Paradox

A paradox is a “situation, person or thing that combines contradictory features.” That is a perfect description for the stock market of the last several weeks – there are contradictory elements that are pushing the market in vastly different directions simultaneously.

What The Market Does

Long-term, the market reflects the direction of the economy, and the market is future-looking. In other words, if today’s economy is good, but the future looks weak, the market turns down; everyone scratches their head because the economy is strong.

If today’s economy is weak, but the future looks solid, the market turns up; everyone scratches their head because the economy is weak.

Into this inherent dichotomy between the current situation vs. future projections, the mainstream media attempts to offer precise explanations of why the market went up or down by as little as 100 points on any given day. Forget the fact that such small movements are inconsequential and today represent white noise. Nobody should try to explain that level of movement.

But even for larger, more significant movements, the media too often attempts to offer an instantaneous reading of the cause of a big move. Any keen watcher of the media realizes that these immediate explanations are almost always wrong. There are often two conflicting explanations offered by two mainstream sources looking at the same market move.

The truth is that in the short term, nobody knows why the market reacted a certain way on any given day. The reason for this is that there are emotions at play, as well as reasoned analysis. The market will reflect the direction of the economy, and there are plenty of serious analysts who work hard to predict that direction, so they know how and at what level to buy or sell stocks. These analysts also climb into the weeds to predict the direction of profits for each company whose stock is being sold. As those go up, the stock price for that company goes up; as that goes down, the stock price for that company goes down.

It is a logical and fundamentally common-sense process. In the short term, though, emotions can distort the process. Buyers can panic and sell stocks that should be retained. Buyers can also get excited and buy stocks that should be sold. These distortions do not last long; they are always corrected by the serious analytical players in the market; but they can cause a lot of volatility. To successfully invest, you need to ignore those emotional swings. You’ll never predict them accurately enough to make money based on that bet.  

How Is The Economy Doing

Since the market is focused on the economy – and all the public companies in that economy – we should understand how we’re doing. And in a word, the answer is “great.” Data can be a bit boring, but they’re important and illustrate the point.

• New orders for durable goods are up significantly
• New home sales are strong, as are new housing starts
• Non-farm payrolls have increased by 500,000 per month over the last year, and unemployment dropped to 5%.
• U.S. private-sector debt – “leverage” – has decreased 45% since 2008
• Real household net worth is at an all-time high of $142 trillion; we’ve never been richer as a country.
• Consumer spending remains very strong, up 12% on an annual basis.
• Corporate balance sheets and profit margins are in great shape.

The major indicators are very strong and bode very well for the future. The market gains from January 1st through August 16th reflected both the then current assessment of the economy and the future potential. Left to its own devices, the economy should continue to improve – returning all measures to their pre-pandemic shutdown levels – and stock valuations reflected that. The Dow Jones Industrial Average was up 16.4% through 8/16/21. Since then, it has fallen off, still leaving us well ahead for the year, but the gain from January 1st through 9/30/21 is now 10.5%.

Why Has The Market Dropped

Here lies the paradox; the economy is good, the economy should continue to do well, and yet we’ve dropped 5% from our all-time high. We don’t believe this is an emotional reaction. There don’t seem to be any of the normal markers for emotions to be the cause.

Instead, we see the cause as being uncertainty out of D.C. as to the direction of tax and monetary policy. It should be self-evident that the profits we referenced above are affected by taxes and by inflation. If a company’s normal profits are taxed at a higher rate, then there are fewer after-tax profits for the shareholders. If a company’s profit margin is squeezed by unanticipated cost increases, profits are also reduced.

The market is trying to determine the future level of those after-tax profits, and there is no consistency right now with regard to what tax rates will be for individuals or corporations or what they will be at various income levels. And yet, we are told that something is imminent from Congress.

Secondarily, there is confusion with regard to monetary policy. $4 trillion in extra cash was created by the Fed over the last 18 months or so. While prompted by the Covid shutdowns, that extra cash isn’t needed now and must be removed to prevent inflation from accelerating. Unfortunately, the Fed is still expanding its balance sheet (a means of injecting cash), has formally indicated it won’t raise interest rates until well into next year, and yet there is “talk” they will start that process earlier.  

So, confusion (which markets don’t like) reins, exacerbated by the political bantering that something has to be done and has to be done soon. It’s not emotions; it’s not the economy; it’s not what the economy should do; it’s what the politicians might do to the economy in the next several weeks. That’s what caused the last several weeks’ volatility and ultimate drop.

What Should We Do

We have solutions for part of the potential problem, inflation, but the other part of this, tax policy, might not require a solution at this moment. The great temptation for too many advisors at times like this is to offer a solution in search of a problem.

As we’ve written before, in an inflationary environment, we are shortening up the maturity of bond holdings and seeking those managers who focus on companies with flexible cost structures.  

On the tax side of this, it could well turn out that the Congress does nothing or agrees on a compromise so tame as to be insignificant relative to the economy’s normal function. Should that be the case, much of the most recent sell-off would reverse itself very quickly.

At this point in time, patience is the most valuable virtue. If we had written at the beginning of the year that the market would be up, say even 7%, most people would have judged that to be a good year. We’re up 10.5% now, down from the high, which was 16.4%. The broader measure, the S&P 500 is up 14.6% now, down from its high, which was 20.7%.

We are not predicting a further fall, but even if another 3% was lost (another 1,000 points on the Dow), we’d still be in a good position. Jumping out of a market that could very well rise in the months to come (and most certainly will in the years to come) would be the greater mistake.

If we get a substantially higher tax policy, we will develop accommodating strategies. We just don’t think triggering sales in this environment is a particularly wise response to the current political environment.

We Are Actually Optimistic

We remain confident in the economy’s current underlying strength, its prospects for the future, and ultimately in its ability to adapt to any tax regimen coming out of D.C.  

In that vein, we remain committed to helping clients achieve their financial goals and to implementing wise strategies and tactical moves to meet both long-term performance goals and near-term liquidity and stability goals. We live in “interesting times”, but we don’t view that as a curse. It’s simply an opportunity to find ways to continue moving forward.