Tuesday, October 9, 2012

Happy Birthday to . . .

Today is the fifth birthday of the all-time high in the Dow Jones Industrial Average, which was 14,164.  That is only 4% above where we are now.

Now, think about the economy five years ago.  It was much stronger.  Unemployment was low.  Home prices were rising.  Everything was good!

So, does the stock market reflect the state of the economy?  The conventional wisdom is that the stock market predicts the state of the economy six months later.  Maybe . . . in normal times!

Five years ago, the economy was drunk on private debt.  Mortgage lending was growing rapidly.  Credit card balances were dangerously high and rising.  Everybody believed in the American dream.

Today, the economy is drunk on public debt.  Government borrowing was rising rapidly throughout the Bush Administration and is rising even faster during the Obama Administration.

Still, why is the stock market so high, relative to the state of the economy?  There is ample evidence that retail investors are sitting in cash, which is not bad, or in long-term bond funds, which is very bad.

The most common explanation is the Fed has produced a tsunami of money with quantitative easing, and it should not be surprising if much of it winds up in the stock market.  Certainly, that explains part of it.

There are also reports that as much as 75% of daily trading is high-frequency trading, which is driven by computers.  This gives me a free-floating anxiety, because I cannot point a finger at the exact problem, but I do remember the "flash crash."

While I'm happy the market is up, I worry that computers are simply driving the money created by the Fed and is unrelated to the economy.