Are financial markets representative of the economy?

While they should be they generally aren’t and not knowing this could hurt you.

Chamath Palihapitiya, a Billionaire and the manager of Social Capital, an investment fund, recently said in a CNBC interview that “the markets are entirely divorced from the economy”.

It’s true, when he said that, we are are going through a global pandemic that has put millions out of work and brought consumer spending to a halt. The market took a dive in March 2020 but bounced back quickly to pre pandemic levels. So is the market really divorced from the economy? well not exactly….

Rule 1: The stock market is valued based on the future prospects of the economy.

So while we may have taken a temporary shock, as long as the impact on the lifetime of the companies that make up the economy is not structurally affected, the stock market will continue to show strength despite the terrible current plight of the economy if it assumes that plight is epehemeral.

But what if the future begins to look bleak? if companies earnings are down for mulitple quarters and not just the current one. What if jobs losses continue and business are slow to recover? Shouldn’t we then see the stock market to decline? Well not exactly……….

Rule 0: The stock market is priced bases on supply and demand.

The best way to understand Rule 0 as it pertains to the stock market, Price v Value, is through a simple thought experiment. If there is a fixed amount of potato supply at your local market and the demand for the potatos has increased rapidly (say a potato salad cookoff at your local elementary), do you expect the price of the potato to stay the same? of course not! the price will go up due to increased demand. Due to the shortage of supply you may even pay more for the same potato even if its quality is bad.

Well apply that to the stock market today, the central banks are printing money to buy assets ( increasing demand) hence the prices of those assets will naturally increase, despite the asstes in question not improving in quality.

This is when “Divorse” occurs.

It doesnt matter if the value based on future prospects of the economy is much below where the stock market is today. If there demand for the stock market is increasing so will its prices. Welcome to the bubble.

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