The Stock Market Cannot Tell Us Which Economic Policies Are Best

The Stock Market Cannot Tell Us Which Economic Policies Are Best
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Valuation-Informed Indexing #381

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By Rob Bennett

President Trump recently said that, if Hillary Clinton had been elected President, stock market prices would have fallen 50 percent over the past year rather than having increased 20 percent. The purpose of the comment is clearly to suggest that his economic policies have been proven to be superior.

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I don’t take a position on whose economic policies are superior. But I strongly reject the idea that the performance of the stock market should be cited as conclusive evidence one way or the other. This is a pet peeve of mine. This sort of claim is made all the time by people representing all political ideologies. I think it would be a good thing if we could all become more skeptical of these sorts of claims.

It’s not hard to see why Trump would be tempted to cite the performance of the stock market as evidence of the merit of his policies. Most people tune out claims that a politician makes for the intellectual merit of his or her policies. Trump could have argued for why tax cuts spur economic growth and I probably would not have learned about the comments because few would have paid much attention to them.

The benefit of citing the stock market’s verdict on his policies is that he is citing what most people view as a neutral source. Policymakers are viewed as biased, economists are viewed as biased, journalists are viewed as biased. The stock market? Stock prices are determined through a process in which incredibly smart people make ruthlessly self-interested, rational decisions. The stock market is not biased. The stock market is objective and hard-nosed. What the stock market concludes re a policy affecting the economy counts.

It’s not so.

At least not according to the last 36 years of peer-reviewed research. It was Eugene Fama’s research of the 1960s that was thought to show that the market is efficient and rational. But Robert Shiller showed in 1981 that it is investor emotions that are the primary determinant of stock-market price changes. Prices don’t go up because of positive economic developments. They go up because of shifts in investor psychology (which in some cases come about in response to positive economic developments and which in some cases do not). If that’s so, then the 20 percent gain in prices that we have seen since the 2016 election does not necessarily say anything positive about Trump’s economic policies.

It could be that the policies are wonderful and that people see that and that people are pushing prices up as a result. But that’s only one possibility. It could be that people are worried about their retirements and believe that stocks offer the highest return and thus are putting more money into stocks to make up for lost time. It could be that the 2008 crash is now far enough in the past that people feel comfortable putting more money into stocks again. It could be that people think that Trump’s economic policies will prove to be a negative in the long term and thus are trying to take advantage of the good returns available in the stock market today out of a fear that they may not last much longer.

It could be all sorts of things. If stock prices are determined primarily by shifts in investor emotions rather than by economic developments, it is hard to say what is the cause of any particular price change. Good economic developments can cause price drops in a world in which price changes are determined by psychology and bad economic developments can cause price increases in such a world. The stock market is not governed by political bias. But, in a post-Shiller world, it is not an objective truth-teller. It is an emotional basket case. We shouldn’t be listening to an emotional basket case for guidance on whether particular economic policies are good choices or not.

I believe that Trump is playing a dangerous game. Stocks have been wildly overpriced for a long time and are due for a big price drop. By claiming that the market’s verdict on his policies is one that should be given respect, he is setting himself up for taking a major hit in popularity in the event that the market delivers a very different verdict in the next year or two.

Is it possible that the recently enacted tax cuts have given stock prices a temporary boost? I certainly view that as possible and even likely. But the key word in that sentence is “temporary.” It seems reasonable to believe that, in the months when the tax cuts were being negotiated but had not yet been made law, the anticipation of future tax cuts pushed stock prices higher. Now the anticipation is over. There will be no additional tax cuts next year. So do stock prices now head downward? It’s possible.

In a world in which stock prices are determined by shifts in investor emotion, just about anything is possible. We fool ourselves if we come to believe that the stock market is able to tell us things policymakers are not able to tell us and that economists are not able to tell us and that journalists are not able to tell us. The stock market is not smarter and more objective than all the rest of us. The stock market IS all the rest of us. It is as smart as we are as a people and as flawed as we are as a people.

Rob’s bio is here.

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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