Psyching Out the Stock Market

It is usually the stock market that psyches us out, not the other way around.

There’s something about stocks that turns us upside down. For example, normally when something goes on sale, we tend to buy more of it; yet, when stock prices fall, many investors want to buy less.

This reminds me of Baron Rothschild’s advice to “buy when there is blood in the streets.” Those who heeded that advice last winter and bought stocks on sale during the depths of the selling panic are sitting on some handsome profits now. As it happened, a relative called me then and said, “I just sold all my stocks. I couldn’t stand watching the prices fall.”

Had I been an astute investor, I would have loaded up on stocks at fire-sale prices after that phone call. I remember wondering whether I should increase my modest holdings of a stock that had crashed to multi-year lows, but I didn’t pull the trigger. That stock has risen seven-fold since then. Oh well, at least I didn’t sell it.

The purpose in telling you this is to demonstrate that I am not a stock-market wiz. As an economist, though, people inevitably ask me to predict the stock market. They shouldn’t. In the first place, my interest is in public policy and how to preserve our freedoms. I don’t find a daily study of stock-market gyrations remotely interesting. In the second place, even those who devote their full time to studying markets are frequently humbled when the market confounds their expectations. The reason is simple: individual stocks and market indexes will rise if more people want to buy them than sell them, and fall if more people want to sell. Question: How can anyone know what millions of other people will choose to do on any given day of the week or any year on the calendar?

Now that I’ve made that disclaimer, here is how I responded to a request for a prediction in late spring when the Dow was at about 8,000: Greg Wheatley, the host of Moody Broadcasting’s “Prime Time America,” asked me during a radio interview to predict a range for the Dow by mid-2010. After reminding the listening audience that my prediction was worth what they were paying for it (i.e., zilch), I ventured a guestimate—a range of 11,000 on the upside and 5,000 on the downside.

My sense was that the market was not done bouncing up from last winter’s lows. Recently, the Dow has been bouncing around the 10,000 level. It may or may not climb that last 1,000 points to 11,000. I would say it’s possible, on a momentum basis, but on the basis of economic fundamentals, the market seems closer to a top than to a bottom.

It is important to remember, however, that the paper economy of the stock market is a different animal from the real economy that I study. It is possible that the stock market will continue to trend higher without the benefit of an underlying strong economy. The largest component of our economy is consumer spending (although President Obama and his team seem determined to make government spending number one). This year, total hours worked and total income have fallen and savings have increased, so it’s hard to picture booming businesses sporting rising profits and stock prices.

Furthermore, banks are not lending. For over five months now, bank lending has declined every week. Consumer, industrial, and real-estate loans have dropped a net $216 billion. That represents a 15 percent yearly rate of credit contraction. In the past, credit has always been expanding at the end of a recession.

With these market conditions, where is economic robustness going to come from?

As I’ve written before (here and here), Team Obama is pursuing policies similar to those that FDR adopted during the Great Depression. Even though those policies prolonged the Depression, there were several major bull markets within the horrible bear market of the 1930s. If history repeats itself, it wouldn’t surprise me if we have a severe bear market by next summer. Dow 5000—my off-the-cuff guess of a few months ago—seems unlikely now with the market near 10,000, but I don’t think the stock market is out of the woods yet.

Now, what could blow my “prediction” (I mean, “guess”) out of the water? In the first place, it can be foolhardy to bet against the resourcefulness and ingenuity of Americans. They always find ways to produce wealth, if the government lets them. Also, the Federal Reserve’s injections of massive amounts of “liquidity” (sorry, in plain English, “money”) into the financial system may drive stocks far higher. During Zimbabwe’s recent hyperinflation, Zimbabweans perceived stocks as an inflation hedge; consequently, many stock prices soared, even as hyperinflation devastated their real economy.

Will the same thing happen here? I don’t know. The only thing I know for sure is that Mr. Market will do his thing independent of what economists and financial experts want, leaving a trail of human smiles and tears in his wake.

Good luck, everyone.