What matters for the stock market is not the state of the real economy as such, but the state of monetary liquidity. In fact, bad economic conditions can actually be good for stocks. This is because monetary liquidity is determined by the interaction between the demand for money and the supply of money, the latter of which is associated with a looser monetary stance during crises.
As economic activity slows down, the demand for the services that the medium of exchange provides in the real economy declines. As a result, for a given pool of money a surplus of money emerges. As a rule, this surplus is put to work in financial markets, including the stock market.
Consequently, the prices of financial assets and stocks are pushed higher. (A deep economic slump also tends to be associated with a strong loosening in the central bank’s monetary stance, which further supports the growth momentum of the money supply.)
This was observed in the 1970s. The yearly growth rate of industrial production fell from 3.5 percent in January 1974 to –12.4 percent in May 1975. The yearly growth rate of the Consumer Price Index (CPI) declined from 12.3 percent in December 1974 to 9.4 percent by June of the following year.
As a result, the yearly growth rate of surplus money climbed from –7.7 percent in March 1974 to 7.6 percent in May 1975. In response to the increase in liquidity—i.e., the surplus money—the S&P500 climbed from 68.6 in December 1974 to 95.2 by June 1975—an increase of 38.8 percent.
Now if the pool of real savings is declining, it is possible that this increase in surplus money will not be employed in the stock market. Instead, investors may prefer to put it in safer assets such as Treasury bonds. This is something that was observed during the Great Depression.
For instance, the yearly growth rate of industrial production fell from 15.3 percent in January 1929 to –24.6 percent in October 1930. The yearly growth rate of the CPI also fell significantly, from –1.2 percent in January 1929 to –6.4 percent in December 1930.
In response to these large declines, the yearly growth rate of surplus money increased from –16.6 percent in May 1929 to 25.5 percent by November 1930.
Despite this strong increase in monetary liquidity, the S&P500 fell from 24.15 in October 1929 to 15.34 by December 1930—a fall of 36.5 percent. The index in fact continued to slide, falling to 4.4 by June 1932—an overall decline of 81.8 percent from October 1929.
I attribute the ineffectiveness of the increase in liquidity in strengthening the stock market between May 1929 and November 1930 to the possibility that the pool of real savings had declined significantly. The ensuing depression and massive unemployment forced people to stay out of any form of investment in stocks. As a result, the increase in liquidity was directed toward assets such as US Treasurys rather than stocks. During this period, the yield on the ten-year Treasury bond fell, from 3.71 percent in August 1929 to 3.19 percent by November 1930.
What is the current US economic background? Economic activity in terms of industrial production growth currently shows a visible weakening. After closing at 5.4 percent per annum in September 2018, the yearly growth rate fell to –1 percent in January 2020. The annual growth rate of the CPI, after having settled at 1.5 percent in February 2019, had climbed to 2.5 percent by January 2020.
The growth momentum of liquidity has shown a visible strengthening since August 2019. The yearly growth rate climbed from –2.7 percent to 4.2 percent by February 2020. The S&P500, however, after closing at 3,231 in December 2019, had plunged by 20 percent by March 2020, closing at 2,585.
