The stock market tells us about the expected value of future after-tax corporate profits. At least, that is when it tells us anything at all.
That is not radical lefty ranting, that is from the Econ textbook. If the economy is expected to boom next year, because Joe Biden is going to use the revenue from a big corporate profits tax to finance huge investment in green projects, there is no reason to expect the stock market to rise.
People will not pay more money for shares of Microsoft, GE, or any other stock because they expect the economy to boom. They will pay more money for shares of the stock in these companies if they expect their after-tax profits to be higher. And if Biden’s tax increase on profits is going to more than offset any plausible increase in profits due to higher sales, then share prices will fall.
Read that again, if it is too simple to understand. If the economy booms, but the after-tax profits fall because of higher corporate taxes (or higher wages) the stock market will fall. (This is when the market reflects fundamental values. Often it doesn’t, as in the late 1990s stock bubble.)
There is no, as in zero, necessary connection between stock prices and the health of the economy. They do often move together, just like the price of wheat tends to rise with a strong economy, but the stock market is not designed to tell us about the economy. It tells us about after-tax corporate profits: Full Stop.
The reason for this tirade is a NYT column by Farhad Manjoo in which he breaks the news that the stock market no longer tells us about the health of the economy in reference to the GameStop nonsense.
“Indeed, a story that was almost proudly disconnected from the real world, telling us so little about the larger economic forces shaping our lives?
“I’m not just talking about GameStop’s bubbly stock price. I’m talking about the entire bubbly stock market, whose gyrations during the last few decades have made it less and less of a reliable proxy for understanding the health of the economy at large — even if presidents and pundits still point to it as a benchmark that makes a difference in people’s lives.”
Someone has to break the news to Mr. Manjoo, and perhaps the opinion editors at the NYT, that the stock market never told us about the economic well-being of the vast majority of people in the country. Again, think of the stock market like the price of wheat. A strong economy will tend to cause both to rise, but there are plenty of other factors that can rises as well.
In the case of the price of wheat, a severe drought or crop failure in a major wheat producer elsewhere in the world will lead to a big jump in the price of wheat. Similarly, a cut in corporate taxes or a weakening of workers’ bargaining power, will typically lead to a rise in stock prices.
The former story is good for wheat farmers, the latter is good news for the small segment of the population that has lots of money in stocks. Neither is good news for the country as a whole. Why is this simple point so hard to understand for people who write about economic issues?
This first appeared on Dean Baker’s Beat the Press blog.