Why the stock market does not drive the economy
For the Appeal
Guy Farmer, Sam Bauman and I were having lunch recently when the subject of the stock market’s relationship to our national economy came up. To those of you who know us as columnists, we may seem an odd lot in that Sam is to the left of center politically, I am to the right and Guy glides down the middle. So if you’re wondering why we get together weekly, it’s to keep each other honest and satiate our appetite for intellectual talk, which isn’t always easy to come by in River City.
Guy made a remark that the market’s recent big one-day drop perhaps signaled the beginning of economic problems. Little did he realize he had pushed my button. One of my pet peeves is commentators and print journalists who somberly report every drop in the Dow as though doomsday is around the corner when in reality, stock market gyrations rarely reflect our nation’s true, long-term economic condition. The stock market is a lag-behind indicator at best, and in no way does it drive the economy. Alan Greenspan’s big mouth has more overall effect on our economy than does the market.
What makes our economy is broad-based business activity and how quickly money passes through each state of the goods and services supply chain – the velocity of money. The faster the better. Are companies selling their products and services at profitable prices? Are they allocating resources efficiently? Are they optimally staffed? Are they expanding market share through R&D? Are they exploring and creating new markets? Do they have productive sales forces? Are their suppliers delivering on time and at budgeted prices? Are national, state and local governments planning more or fewer expenditures, and in what markets?
These are a few of the elements that drive our economy, and you can see they are independent of the stock market except in those instances where the market is called upon to underwrite new companies with capital (IPOs), or issue secondary shares to raise additional capital for already public companies. Other than new and secondary stock issues, the level of the Dow and its companion indices have no direct effect whatsoever on the economy. Stock prices are a gigantic crap-shoot in which you buyers of shares hope that someday somebody will pay you more for your shares than you did. Of course, smart buyers demand dividends along the way.
When my dad was managing Paine-Webber’s Anaheim brokerage, he and I disagreed on this because he refused to admit that once stocks are on the market the only people who may or may not benefit are the gamblers who buy and sell those shares, and company executives who hold those shares. The companies do not benefit from stock transactions between investors. And the effect on the economy is neutral because that money was already in the economy, formerly in the hands of the buyers.
The best first-hand example I can give you on how the economy isn’t directly affected by stock market activity is when my partners and I sold our high-tech company. We hadn’t intended selling, as we had already made arrangements with Paine-Webber to take us public in three years. But a top company with which we’d had a profitable business relationship surfaced unexpectedly and wanted to buy us. We told management we weren’t for sale but the company countered with the news they had just gone public and we could piggy-back on the expected monetary growth of their stock because at issue time it was grossly undervalued.
We accepted, and took “X” of their stock for our company with the provision we would operate independently for three years, during which if our firm doubled our after-tax profits, their firm must double the original number of shares traded to us for our firm. To make a long story short, we earned our 100 percent stock bonus, but because we were restricted from selling any stock for two years on the first batch and another two years on the bonus batch, it was five years before we could sell all of our stock. However, during those restricted years, thanks to our bonus stock and two splits, the value of our shares increased eight times over what they were when we made the deal.
Now, did our increased stock value at the end of those five years help our company and the economy? Yes! But while the increased stock value made you investors and us owners very happy, when we sold our stock none of that money went into our company or directly into the economy. It came to us owners and it was already in the economy transferring from the buyers to us.
Once again, while the economy is affected by many elements, it is separate and apart from the stock market. Over time, the stock market will reflect economic conditions, but sudden changes in the Dow and other indices are not a reliable economic indicator.