Do Capital Markets Create Their Own Fuel?

Economic forecasters sometimes describe capital markets as a leading economic indicator, which assumes that share prices of equity securities anticipate good or bad economic conditions:  Share prices rise when investors expect economic growth, and fall when economic recession is expected; or so the conventional wisdom says.

But can capital markets actually create or destroy the very economic conditions that their participants are anticipating?  Isn’t this the purpose of a “capital market,” to facilitate the buying and selling of securities (equity or debt), in the interest of raising capital for corporate and government objectives, which is usually to finance growth of the respective enterprises?

Are the participants in capital markets (investors) buying or selling in anticipation of future economic conditions AND thus contributing to the anticipated economic condition?  Do capital markets have an inherent self-fulfilling prophecy effect?  Do capital markets create their own fuel?

These are not rhetorical questions.  I would like some education. I’m a CFP with an MBA but certifications and degrees don’t help me (or anyone) as much as the study of philosophy, which makes me fully aware of my own ignorance.

So please read a bit more and share your wisdom with me and others in the comments…

The idea for this post, and thus the inspiration for the questions I’d like for you to answer, came from a statement made by Alan Greenspan this past Sunday on Meet the Press (full transcript here):

“…as I’ve always believed, we underestimate the impact of stock prices on economic activity. Asset prices are having a profoundly important effect. What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We’ve come all the way back–maybe a little more than halfway, and it’s had a very positive effect. I don’t know where the stock market is going, but I will say this, that if it continues higher, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about.”

Do we really “underestimate the impact of stock prices on economic activity?”  Greenspan’s statement, at first, seems to make sense; but aren’t stock prices a leading economic indicator, a discounting mechanism, reflecting an anticipation of future economic conditions?   Or are capital markets a creator and destroyer of economic conditions?  If so, what makes stock prices rise or fall?

Consider the logic of this statement:

Stock prices rise when investors anticipate a growing economy; and the economy grows as a result of rising stock prices.

In philosophy, this statement might be considered fallacious logic, or what is called a circular argument; where one assumes in the premises the same that is to be proved in the conclusion.  I thought of this circularity when I heard Alan Greenspan speak.

But is this circularity, or might it be something akin to the idea of momentum investing?  Furthermore, what was the first mover starting the rise in stock prices in 2009?  Was it just hope or was it anticipation of a growing economy? Are there times when stock prices are not actually forecasting economic conditions in the near future; but they are actually creating the capital that stimulates the economy;  and hence creating a kind of self-fulfilling prophecy?

So which is it: Are capital markets leading economic indicators or are they leading economic funding for growth?  Is it both?  Is it sometimes one or the other?

“Nobody goes there anymore; it’s too crowded.” ~ Yogi Berra

This brings to my curious mind another question, which may bring up other questions:  If you think the economy is headed for a double-dip recession, and therefore investors are “wrong” for buying into long positions of stock, might this seemingly poor judgment end up fulfilling its own prophecy by enabling economic growth, making these supposed foolish optimists “right” for buying now?

As Barry has said here at TBP before, the crowd is “right” most of the time.

Also, perhaps part of a greater-known investing mantra, “Don’t fight the Fed,” may help answer some of my questions here today: With Greenspan’s statement that stock prices “will do more to stimute the economy,” he implicates the Fed’s wink-wink relationship with Wall Street; to provide fuel for capital markets, which indirectly fuels the growth of the US Economy.

Or perhaps Ben Graham answers some of my questions in his famous assertion: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

“True wisdom comes to each of us when we realize how little we understand about life, ourselves, and the world around us.” ~ Socrates

Please share your wisdom.   I reserved this post idea specifically for you, Barry’s readers, because I knew you would provide a diverse array of wise, educational and/or colorful comments…

What are your thoughts?

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Kent Thune is blog author of The Financial Philosopher.

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