The relationship between equity prices and the real economy
Posted on 04 March 2010
A May 2007 paper by some fellows at the St Louis Fed looked at “Monetary Policy and Stock Market Booms and Busts in the 20th Century“. It’s worth a read if you have the time. The following charts are taken from it:
Expanding money supply may be expressed in the host’s equity market – and/or any other sector(s) of its asset markets. It could also escape into consumer price inflation. Or it could actually be used for productive investment. The point is that if money supply is expanding faster than the fundamental economy, the excess supply will find a home.
This is a theme we shall explore in more detail at another time. For now wanted to explore a variant of this concept with respect to the equities market – the idea that the equities market can get ahead of the real economy when risk appetite and expanding money supply conspire to juice things up:
This chart isn’t so simple to read given that the absolute range of outcomes – on the face of it we are sitting in the middle of the long term range. It also doesn’t take into account the substitution of equity for debt (and vice versa) that is one of the objectives of our analysis. A better interpretation perhaps is that provided by relative market capitalisation. I’m still on the hunt for raw data but in the meantime consider this chart from The Chart Store (via The Big Picture):
It makes for an interesting comparison…
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That final chart is an interesting one. I guess it underlines the ‘financialisation’ of the US economy (and most advanced economies). It would be instructive to see the same chart for the UK, which has possibly been even more ‘financialised’ than any other economy.
But it raises the question – should the equity markets neccesarily follow in line with trend GDP growth? Should it matter that equity markets have a higher value than the nation’s GDP? It’s hard to say really.
It’s been taxing my synapses. Intuitively there should be a link between GDP and equity market capitalisation – but it depends on the market. The US has a relatively high tech component that should grow faster than GDP (ie. efficiency gains) while the financials should be anchored more to GDP given their earnings are ultimately a function of demographics (and in the shorter term, leverage in the system).
I’m putting together a chart on international comparisons…