Stock Market Is the 'Keystone Bubble' Right Now

Wednesday, 04 Aug 2010 10:02 AM

By Robert Wiedemer

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The more you look at the economy right now, the more it becomes obvious that the “keystone bubble” holding up the rest of the economy is the stock market.

There has always been a lot of talk during past market downturns that Wall Street can move down and Main Street can still move up — as what happened in the 1987 crash.

The economy quickly recovered and moved strongly upward. After all, stocks don’t drive the economy, the economy drives stocks. But this time the stock market is playing a key role in driving the economy.

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It is no coincidence that so many charts of various indicators of economic growth in 2009 show a big turnaround in spring 2009 when the stock market rallied — from drilling rig counts, to consumer spending, to travel. So much of the economy only moved back into growth mode when the stock market moved into growth mode.

Of course, the stock market moved into massive growth mode whereas the economy simply moved to modest growth from decline. That’s because the effect on the economy from the stock market is limited, but still quite clear.

Many people would say the market is merely reflecting growth in the economy. But, the economy really didn’t turn around until after the market started to turn around. And, of course, the stock market began its major long-term move upward only after the Fed started its massive purchases of government bonds, which was key to kicking off the stock market rally.

The key question is why and how the stock market would have such a pronounced effect on the economy. I think part of the reason is due to so much spending being driven by the top 20 percent of income earners. Estimates vary, but it appears that as much as 40 percent of spending in the United States is driven by the top 20 percent of income earners. That part of the United States is heavily influenced by the stock market since a large part of their wealth is invested in the market.

In the recent recovery, savings rates have gone up and stayed up for much of the middle class, whereas savings rates for top income earners went up during the stock-market downturn, but have since turned negative again, as was most everyone’s before the 2008 bust.

Again, the wealthier part of America is spending more than it is earning. That’s a big shot in the arm to the economy. Mark Zandi, Moody’s chief economist, recently said that much of the recovery was driven by the wealthy.

I think that is a good observation. Alan Greenspan made a similar observation just a few days ago.

Let’s keep in mind that when I say "wealthy," I don’t mean people who always shop at Tiffany’s. The top 20 percent are the people who vacation at Disney World, upgrade their kitchens, buy new cars and go to restaurants. All the types of spending that have rebounded since the stock market went up.

The top 20 percent also includes a lot of business owners and others who drive business spending. If they are more confident in their own personal financial situation, they are more likely to make business-related purchases as well. Again, this effect is limited, which is why the economy is sluggish, but it is significant — which is why the economy is no longer declining and growing slowly.

So, if I were to predict the next downturn in the economy, I would predict it would come when we have the next downturn in the stock market. I think the correlation is that close.

Again, a bubble economy is different from a regular economy.

In 1987, the economy drove the market. In the current economy, the psychology surrounding the stock-market bubble is key in driving the consumer-spending, private-credit and the housing bubbles.

Housing is less driven by the top 20 percent of income earners and that’s why it has been slower to recover than other parts of the economy, although it has recovered somewhat in some wealthier markets such as New York City and San Francisco. Again, that further shows the impact of the stock market on the economy.

It’s an unusual time we live in, but let’s see what happens when we get the next market downturn.

Show me a Dow at 7,500 and I’ll show you a significantly slower economy.

Because of that, I think we’ll also see a Fed that is more than happy to go in and buy more bonds with printed money to revive the stock market.

There is already discussion that the Fed will buy more bonds (QE as they call it) if the economy slows down. If the stock market really tanks, I think they will more than willing to start printing again to buy bonds.

It’s a great solution short-term and a terrible solution long-term. But, I think that’s what they’ll do. It worked before and it will again — this time.

Of course, the Fed can only pull the rabbit out of the hat a couple of times before inflation finally hits and the true impact of what they have done becomes obvious.

About the Author: Robert Wiedemer
Robert Wiedemer is president of the Foresight Group, a macroeconomic forecasting firm that customizes its forecasts for specific businesses and investment funds. He is a regular contributor to Financial Intelligence Report, the flagship investment newsletter of Newsmax Media. Click Here to read more of his articles. Discover more about his latest book, Aftershock, by Clicking Here Now.

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