Be Your Own Economist ®

Be Your Own Economist ®

The Dow closed at a record high yesterday, raising the following question in the minds of some.

“If the economy is getting weaker and there are omens of even more weakness in the future, why has the stock market done so well?”

Media accounts of yesterday’s surge in The Wall Street Journal (http://online.wsj.com/article/SB119128789016645927.html?mod=hps_us_whats_news) and The New York Times (http://www.nytimes.com/2007/10/02/business/02stox.html?_r=1&ref=business&oref=slogin) credited banks’ handling of the mortgage crisis for part of yesterday’s gain. A number of big banks took a loss to reflect declining mortgage values in their portfolios, and that should put the worst of the crisis behind them. With subprime problems behind it, the financial sector can move on to better things. That thinking, according to analysts, raised investors’ spirits across the board.

But there is more to the stock market’s gains. Investors see the Fed’s recent rate cut as merely an hors d’oeuvre. There are more reductions on the horizon. If the economy weakens further, the Fed will offset any and all setbacks with additional rate cuts. Just as the 2001 – 2002 rate cuts propelled the economy and stock market forward, so will today’s cuts. The Fed will nip any recession in the bud.

Moreover, falling interest rates are good for stocks under any circumstances. As rates decline, the interest-earning alternatives to stocks look less attractive. Falling interest rates will drive investors out of these alternatives and into stocks. The market will rise.

So far so good, but two offsetting scenarios remain. First, it’s possible that interest-rate reductions will not halt the economy’s slide. Residential construction activity may continue to tumble because falling home prices more than offset falling interest rates. Prospective buyers may not want to build in an environment of falling home prices despite drooping interest rates. That remains to be seen. Second, although the Fed’s interest-rate reductions did contribute to the economy’s 2003-2004 recovery and revival, that’s not the same as saying the Fed’s rate cuts forestalled recession (and the dot.com stock-market debacle). Both the economy and the stock market retreated substantially before recovery began.

If history is a guide, it may mean that the stock market’s recent burst of optimism does not necessarily forecast the economy’s (or the stock market’s) rosy future.