by Rob Bennett

If you want to know what’s going on in the economy, you talk to an economist. If you want to know what’s going on in the stock market, you talk to a fund manager. We have economics experts and we have investing experts, but it’s hard to think of anyone who is widely viewed as being an expert on both subjects.

That’s too bad. Stock market developments have a huge effect on the economy. When the Dow falls 1,000 points, millions of people become worried about their financial futures. They spend less. That reduces profits for tens of thousands of companies. Those companies fire hundreds of thousands of employees.

There are lots of things we look at to explain what is going on in the economy. We look at Federal Reserve decisions to tighten or loosen the money supply. We look at whether inflation is increasing or decreasing. We look at housing starts and consumer confidence and political developments and to signs that we may be seeing terrorist attacks or wars. Why don’t we look at what is going on in stock market?

Falling or rising stock market prices have a bigger effect than any of these other factors. And this effect can be quantified.

It’s easy to see why people think that a terrorist attack will have a bad effect on the economy. But it’s hard to imagine how anyone could arrive at a good assessment of how how big that effect would be. When stock prices go up or down, we know precisely how much spending power is being added to the mix or subtracted from it. There’s no other factor likely to reveal as much about where the economy is headed as the change in the stock market price.

So why don’t economists pay more attention to this factor?

It’s because the conventional economic belief today is that the causation works in the other direction.

Eugene Fama’s Efficient Market Hypothesis posits that the stock market incorporates the effect of all economic developments into its price immediately after they take place. If this were so, it would be impossible for changes in market prices ever to affect the economy.

But what if it is not so? What if it is Shiller who has it right, not Fama?

Shiller’s 1981 research showed that valuations affect long-term returns. If valuations affect long-term returns, knowing today’s valuation level tells you whether prices are headed upward or downward in years to come. If we can know in advance whether prices are headed upward or downward, we can know in advance whether the market will be adding spending power to the economy or subtracting spending power from the economy. If Shiller is right, changes in stock market prices can cause economic growth or economic collapse and both the upward and downward economic swings can be predicted by those paying attention to stock valuations.

Shiller predicted the economic crisis.

People think of Shiller as an investing expert. The full truth, however, is that he is a professor of economics. And Shiller used his knowledge of how stock markets work to predict in March 2000 where the economy was headed over the next 10 years.

He said in his book Irrational Exuberance that: “Individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.”

Shiller knew that the insane level of stock overvaluation we all permitted in the late 1990s would cause an economic crisis. He has been proven right. We could have prevented this economic crisis had we listened. We can stop the economic from growing worse by listening now.

The first step onto a better path is acknowledging the holes in Fama’s Efficient Market Hypothesis that were discovered by Shiller 30 years ago. It’s not economic developments that cause the sorts of insane stock prices we saw in the late 1990s. it’s the sorts of stock prices we saw in the late 1990s that cause the economic pain we are all experiencing today.

To stabilize the economy, we need to stabilize stock prices. We do that not by promoting Buy-and-Hold strategies but by warning investors of the dangers that follow from coming to believe that it is okay to stick with the same stock allocation in the face of wild valuations shifts.

Rob Bennett writes about Stock Valuation Made Easy at his web site. His bio is here.