Pessimists say the equity market’s rally is produced by nothing more than stock buybacks. The pickup is enriching shareholders, doing little for economic growth, the thinking goes. But this criticism overlooks the real economic benefits of rising share prices.
Conventional wisdom suggests that the stock market has two main channels to the economy. First, rising share prices help reduce the cost of capital for a company and that, in turn, boosts business investment. Second, higher stock prices increase the wealth of households, which can stimulate consumer spending. Third, and less widely understood, stock markets can be an important aggregator for information and macro uncertainty.
Any discussion of the link between stocks and investment can reasonably start with a discussion of the economist James Tobin’s Q-theory of investment. The Q is the ratio of the market value of a company’s assets, as proxied by stock prices, divided by the replacement cost of those assets. If buying an extra widget adds more to the value of a firm than it costs to buy it, then the company will lift its stock price by buying the extra widget.
That theory isn’t especially controversial. The broad equity market was essentially flat from late 2014 to early 2016 and, unsurprisingly, nonresidential business fixed investment was, too. Since then, stock prices have been on the mend and business investment has followed. Indeed, equipment and software spending has been rising as a share of gross domestic product alongside the Q ratio. Don’t be surprised to see investment spending rise in the quarters ahead.
An important corollary to this analysis is the notion of the equity market as a financial accelerator. A rising stock price means stronger balance sheets and more collateral against which to borrow. This could make a firm appear less risky to lenders. So, there is a positive feedback loop during an equity market boom: Rising stock prices lead to looser lending standards, which lifts investment, boosting the economy and reinforcing the upturn in stock prices.
The direct link between stock market wealth and consumer spending is more difficult to pin down. Estimates are wide-ranging, from as low as 1 cent for every dollar in stock market wealth to as much as 5 cents. Because there is limited dispersion of financial assets among households and since most equity market wealth is held for retirement or bequest purposes, the direct wealth effect from higher equity prices is quite low. Stock prices also tend to be volatile and households may not necessarily see gains in stock wealth to be persistent.
On the other hand, the market does play a role of relaying information to the public. Normally, if a company’s share price is rising, that shouldn’t tell the chief executive anything about his firm he does not already know. The Merrill Lynch strategist Bob Farrell once quipped, “Bull markets are more fun than bear markets.” For households looking at the broad trend in all stocks, a bull market in stocks tells them a story. Right now, the surge signals good times, boosting household confidence.
Confident households tend to draw down their rates of saving. Recall that saving is the difference between income and spending, not wealth and spending. If good times are ahead there is less need to build up precautionary savings today. Unsurprisingly, there is a reasonable strong negative correlation between a higher wealth ratio and the personal saving rate. So, in a way, rising stock prices can lift consumer spending by making households feel comfortable to spend more of their income.
Today, we see a positive feedback loop forming between the stock market and the economy. Dismissing the rise in stock prices as doing little for the economy is misguided. Quite the contrary, the increase is more likely a harbinger of stronger growth ahead and a reason for firms to invest more today.
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