One of the most common ideas floating around is that the real economy must be on its way to recovery because the stock market, which is often a leading indicator, is recovering. The mainstream economist will tell you that the contradictory newspaper headlines that we showed in our previous article are not really contradictory at all. They will say that since the stock market is a leading indicator, then it will bottom out first before the real economy bottoms out. According to their logic, that’s why you can see rising unemployment and rising stock prices simultaneously.
The idea that the stock market predicts the business cycle is a very dangerous one for the investor. The truth is that, as we said before in Is this a bear market rally or a turning point?,
To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery.
So, assuming that this stock market rally does not signify an economic recovery, what will be the outcome? The deflationist believes that this rally will eventually run out of steam and collapse into a rout. The inflationist believes that the worse the real economy is, the bigger the bubble in the stock market will be (see Should you be bullish on stocks?) because of unprecedented money printing.
If you subscribe to the inflationists’ view then it follows that should the real economy recovers, then it will be very bad for the stock market. To understand why, consider what will happen if the real economy really recovers:
- Stimulus will be withdrawn.
- The Federal Reserve will mop up the ‘printed’ money from the financial system.
- Government tax revenue will increase sustainably, which means the the size of the budget deficit can decrease, which in turn means that the government will be less sensitive to rising interest rates by the Fed.
- The Fed will then raise interest rates.
A truly recovering real economy will result in liquidity draining out of the system. Since the current rally is fuelled by massive loosening of liquidity, draining liquidity will imply that the stock prices will fall and the US dollar strengthens. As the US dollar strengthens, then the short squeeze in the US dollar will happen (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which implies that the Aussie dollar and stock prices will tank.
So, beware of the stock market rally!
Tags: bubble, Federal Reserve, liquidity, stock market
