February 21, 2018 / 2:45 PM / 4 months ago

Breakingviews - Hadas: Put stock markets in their modest place

LONDON (Reuters Breakingviews) - “What about that stock market?” Share prices are a bit like the weather, an easy topic for conversation. U.S. President Donald Trump is fairly typical in gloating when American stocks go up. However, some sensible people – economists and central bankers – also take share prices seriously, especially when they drop as far and fast as they did in the recent selloff. But really, what about that market? Is there any good reason to care?

A trader points to a stock chart on the floor of the New York Stock Exchange shortly before the closing bell in New York July 2, 2014. REUTERS-Lucas Jackson

Economic types sometimes say share prices matter because stock markets are an important source of investment capital. If that is true, then rising prices might make it easier to raise money to expand production, which would be good for the economy. The opposite would be the case when prices fall.

Though the logic is doubtful in any case, the premise is simply wrong. Public equity markets are not significant sources of financing for capital expenditure. Over the last five years, average annual global issues of primary – that is, brand new – shares raised a mere $321 billion, according to Thomson Reuters Deals Intelligence.

This is only 0.5 percent of the world’s total stock market capitalisation. It is also about one-tenth of what listed companies earned in 2017, according to estimates from fund manager Star Capital. In other words, almost all corporate investment – both for maintenance and expansion of production – is funded by companies’ operating cash flow.

When companies do call on outside capital, the first choice is usually debt, not equity. And when fast-growing new companies bring in equity, they increasingly sell shares going public. Private fundraising averaged $178 billion annually over the last five years, Thomson Reuters Deals Intelligence reports. In short, what happens in the stock market has precious little effect on the stock of capital.

Another argument for paying attention to share prices relies on spurious economic thinking. Higher share prices, it is said, create more real wealth, which brings more purchasing power. This in turn leads to more actual purchasing and more economic growth – and vice versa for lower prices.

Not really, though. To start, any increased wealth is more hypothetical than real, since substantial selling would lead to sharply lower prices. Besides, even if sellers do end up taking out more money than they put in, the buyers have to pay exactly the same amount more. Stock market prices can certainly shift wealth, but the total purchasing power does not change.

Then there is the semiotic interpretation. A rising market could be a sign of a booming economy. The investing class’s wise intuition of forthcoming good economic news may lead to net buying in the stock market, pushing up prices. And vice versa.

That lovely theory is unlikely to be true. Investors’ average gut feelings about economic trends probably do influence share prices, but crowds are not always wise. Sometimes they are just ignorant, emotional mobs.

In any case, these days murky psychology has less influence on share prices than cold hard calculations. In particular, so much share trading is financed with borrowed money that the availability and cost of loans is the dominant factor in determining the net propensity to buy or sell.

This dependence on financial conditions explains why stock markets are so sensitive to actual and expected changes in central bank policy. As a result, stock markets often give false economic signals, falling when the economic news is good.

The last argument for paying attention to share prices relies on even murkier psychology. Perhaps market winners spread more economic happiness than the losers spread grief. In that case, rising prices would be good for the economy because, net-net, they encourage spending and investing.

This self-referential claim is deeply illogical. Since share prices are such poor indicators of anything in the actual economy, they should have no more effect on it than astrological events or weather patterns. However, economic behaviour undoubtedly does have some herd-like qualities.

Mass belief in the meaning of market movements probably influences reality, at least for a while. Higher share prices increase confidence among holders, who tend to be affluent and influential. And while they also tend to be educated enough to see the fallacy, they rarely bother to think this question through.

Sum it all up, and the only good reason to treat fluctuations in share prices as meaningful is that too many people who could know better mistakenly think that they are. Unfortunately, this illogic is not merely a subject for study in behavioural finance. Unsubstantiated crowd-think leads to economically destabilising momentum investing.

People justify buying shares in a bull market with the false theory that rising prices signify a strong economy, and the coming GDP growth justifies further share price rises. That is fine while it lasts, but a reversal can be devastating. The right answer is not to keep bull markets going forever, or to re-inflate bubbles once they pop. It is to stop worrying so much about stock markets in the first place.

Breakingviews

Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.


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