How Stocks Go Up in a Weak Economy

Wednesday, 20 Nov 2013 07:29 AM

By Patrick Watson

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Read today's news and you will notice two seemingly inconsistent facts:

• According to unemployment, retail sales and consumer confidence numbers, the U.S. economy is still recovering very slowly.

• Bullish investors pushed the Dow Jones Industrial Average and the Standard & Poor's 500 to record highs this month.

How is it possible for these conditions to co-exist at the same time?

One common explanation is that the government is somehow manipulating economic data. I don't believe so. The bureaucratic number crunchers do make mistakes and refine their methodology, but private sector economists reach largely the same conclusions.

The better answer is that corporations, as well as investors, are responding rationally to the incentives and constraints before them. The apparent disconnect makes perfect sense once you understand three major forces. Each of the three reinforces the other two.

First, the recession allowed and/or forced businesses to get more efficient. They did so mainly by reducing inventory and personnel costs.

The economy bounced back from past recessions because employers rehired their laid-off workers in order to crank up production again. The 2008-09 recession was different. Companies found ways to resume or even increase production with fewer employees.

Today a combination of new technology and international outsourcing allows companies to increase sales without adding staff. The result is higher profit margins, which makes the stock of these companies more valuable.

The second force is corporate cash. With higher profits rolling in, corporations found they were making money faster than they could spend it. Rather than let their deleveraged balance sheets draw the ire of corporate raiders like Carl Icahn, companies raised dividends and/or bought back their own shares.

Higher dividends and share repurchase programs are both very bullish for stock prices. Fewer shares outstanding make remaining shares more valuable. A higher dividend yield attracts income-driven investors who would otherwise buy government or corporate bonds.

This brings us to the third force: Federal Reserve policy that promotes persistently low interest rates. This reduces the gap between bond yields and stock dividend yields, making stocks more attractive. It also helps businesses finance new investments in labor-saving technologies, further increasing profits without increasing employment.

These three factors — productivity, share buybacks and low interest rates — are great for stockholders but do little to help workers and consumers. They are the reason Wall Street is presently much happier than Main Street is.

At some time, businesses will reach a point where they cannot sustain profit growth without higher household income and consumer spending. I don't know when that point will come, but I am very sure it won't be fun for anyone.

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