Interesting Times

30 July 2007



US GDP Rises While Dow Jones Plummets

The US government announced last week that second quarter GDP growth was up 3.4%. This surprised analysts who expected something less dramatic. As Reuters reported, “The strong growth figures helped lift stocks into positive territory in early trade but they later slipped as credit worries reemerged.” From Monday to Friday about 4% was wiped off the equities markets, and the GDP news couldn’t reverse it. What does it mean when GDP goes up and the stock market still drops? It means that the market stopped listening to common sense.

Economics textbooks say that markets are driven by supply and demand, but as anyone who has operated in finance can attest, the drivers are really greed and fear. Neither is a rational beast, and expecting markets to operate rationally at times of heightened greed or excessive fear is folly. The US market may just be at such a point.

The stock market is probably overpriced. That isn’t to say that there are no stocks out there worth buying, but rather that there has been a lot of money put into equities of late. Prices have far outpaced growth, and whenever that happens, there is a risk that investors will wake up one morning and decide to close out their positions. If enough do that, the market as a whole retreats. That is what happened last week.

The Dow is still about 1,000 points higher today than it was on January 3, the first day of trading in 2007. That represents an increase of more than 8%, far more than the economy itself has grown. Unless stock prices had significantly lagged the economy in the preceding year (and they hadn’t), the rise in stock prices is caused not by a strong underlying economy but by asset inflation. More money going into the stock market drives up prices; too much money chasing too few goods.

The partial correction that hit last week is typical of corrections that stem from asset inflation. When the price of the stock exceeds the value of the stock, the premium reflects anticipation of future success. When things like the sub-prime mortgage market and $77 a barrel oil sink in, traders and investors realize that they’ve moved too far too fast. Then, the fear has them running to the sidelines.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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