Bad Economy = Good Stock Market?

bad economy good stock market To most this makes absolutely no sense and, in fact, sometimes the stock market does defy logic for long periods of time. But – this isn’t one of them.

There is a belief that the stock market does better under Democratic Presidents than under Republican Presidents. Believe it or not, this is actually true and the reason is quite simple, if you know how the markets work. And, it’s not because liberal ideas are better for the country.

You see, Democrats love to tax, spend and give OUR tax dollars away to their supporters and the lazy. These policies are detrimental to a growing economy. (Stay with me here for a minute and it will all make sense.) But, America has had and still has a resilient economy with business owners who are excellent at adapting to changing political winds. So, even during a ‘tax and spend’ administration the economy can still manage to plug along, although at a slower and more uneven pace in spite of these policy headwinds.

A slow growing or struggling economy is one where the Federal Reserve (the FED) wants to apply stimulus to the economy to strengthen it. One method that the FED has to do this stimulus includes lowering short term interest rates so businesses and individuals can borrow at low rates and they can spend more money which grows the economy. Another operation the FED can do is purchase government bonds, thus taking the paper out of the system and flooding banks and wealthy entities with cash. The FED does this so that banks will have more money to lend and interest rates will be held down – both of which help to provide the economy with stimulus and liquidity.

However, when government policy includes, raising taxes, spending more taxpayer money and writing more regulations that cost businesses more money to comply, then this drag on the economy offsets the stimulus the FED is applying to stimulate the economy. The end result is an economy just plugging along and a FED who has to keep rates artificially low and pump billions of dollars into to keep afloat. This is the situation we have had under nearly the entire Obama Presidency once the initial recession was halted with drastic FED moves and, unfortunately, unwise government stimulus attempts.

Remember, the FED has been also doing something called Quantitative Easing (QE). QE is the mass purchase of government bonds to flood the economy (the banks and the wealthy) with cash. The FED has been doing QE at the rate of up to $80 billion a month! This is some serious cash! Actually, it is unprecedented and equates to a rate of nearly $1 Trillion per year! This is an incredible amount of money flowing into the banking system and yet the economy just plugs along because of the drags  created by Democratic policies offset what the FED is doing to stimulate the economy.

OK, so now we see that we have an economy that is just moving along in neutral with the ying and yang of government pulling at it in both directions. Should you question that this is, and has been, the state of the economy for the last several years, consider that a normally growing economy creates over 400,000 (400k) jobs each month (we create about 200k to 300k now which barely keeps up with population growth), employment participation increases (it is at a 40 year low presently), job growth goes to citizens (currently ALL job growth in the last decade has gone to foreign born workers) and the real employment rate declines (true measures of the employment rate show unemployment in the 12% to 18% range).

Why is all this good for the stock market when it sounds like it should be bad for stocks? As it turns out, the stock market is forward looking and it weighs what appears to be coming down the pike in the future. When the economy is showing slow growth and interest rates are low and going lower, market participants see corporations, and thus stocks, poised to grow quickly with low interest rates and easy money. The next step for the economy and business is usually faster growth. Until that happens, interest rates and easy money will rule. The stock market participants are anticipating faster growth in the future and thus are buying stocks to participate in that growth.  This drives stock prices up BEFORE the large growth takes place.

Remember, we said the FED is pumping money into the banking system with QE. This money has to go somewhere and much of it finds its way into stocks. At the rate of up to a trillion dollars a year, huge upward pressure is put on stock prices. The forces presently are all pointing to higher stocks. Of course, the FED QE and interest rates can turn on a dime should the economy start to expand at a faster rate. That’s why you will see the market dip on good economic news in anticipation of possible FED policy change. Slow growth and QE is the recipe for a rising stock market.  But the market is fickle, and often, even with rising interest rates will see growth overriding initial rate increases hoping for a further policy stalemate resulting in steady, slow growth and no need for further FED tightening.

Earlier I said the stock market does better under Democrats than it does under Republicans. Why is that? The reasons are many but to put it simply, after many years of Democratic tax and spend policies, when Republicans regain power in the White House and the Congress, more sensible polices are put in place. Over regulation of industry is reduced or reworked to be more favorable to business growth. Also, the tax and spend policies are reduced or, in a few areas, reversed. This creates a better environment for business and business starts to expand at a faster rate. More jobs are created and the economy expands robustly. This increase in the expansion of the economy eventually bumps up against the limits of business growth and available workers. More workers spend more money as do businesses as they expand. This results in inflation in prices and/or wages.

When the FED sees these forces starting to put pressure on prices (inflation) it has to act. The FED is charged with not only controlling economic growth but also with containing inflation. How does it do this? Well, it pretty much does just the opposite of what it has been doing under the Democrat’s control. The FED will begin to raise short term interest rates and start selling or retiring its Treasury bond holdings. These actions cause business borrowing rates to rise and cash to be pulled out of the banking system. This in turn, pulls cash out of the stock market and causes businesses to curtail expansion and hiring as costs to expand business increase.

Market participants see that interest rates are now rising and cash is flowing back to the FED. When it becomes obvious that interest rates are going to rise high enough to slow growth, the market participants begin pulling their money out of the stock market also. All of this, of course, causes the markets to drop – sometimes for years as government policy stays pro-growth and the FED remains in tightening mode. The end result of this is usually eventually another recession and sharp stock market retraction or, more rarely, a ‘soft landing’ if the FED can engineer it. Usually it can’t.

Now that you know what makes the longer term stock market move and you have some basics about how the economy works, you should be able to take advantage of these cycles and make some money investing. You now know generally when to invest in stocks and when to be in cash. The one caveat is that determining when these things begin to change is not always easy. And often they don’t last for years as has the current slow growth economy with prolonged FED QE. Often the path isn’t so clear for the FED and the market will move erratically as it tries to understand the state of the economy and the intentions of the FED.

Just remember that this article is a greatly simplified explanation of how the economy works and what moves the stock market. I suggest you continue reading books that expand upon this analytical direction and don’t lead you in a different or flawed direction.

if the economy is so bad why is the stock market going up

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