Why do stock markets fail to reflect the state of economy?
The market trends seem counter-intuitive and don't seem to reflect the sentiments of the society. I present a macro-economic theory to explain the trends of last 3 years and prediction for 2024.
The stock markets seem to move in mysterious ways.
In 2020 at the peak of COVID crisis when people were losing lives and livelihoods, small businesses were collapsing and there was so much uncertainty, but the markets were booming.
In 2021, when the end of COVID crisis was near, people started traveling again, schools and offices reopened and there was finally hope of a return to life as we were used to, the markets had the worst year.
In 2023, when governments around the world started talking about inflation and imminent recession, the markets were booming again.
This is confounding to many. In this post I am going to explain a key macro-economics theory that might explain what moves the markets.
Before we get into it, let me introduce myself. I am Gaurav Kukreja. I am an Elite Popular Investor on eToro and manage funds over $1.6M for over 800 copiers on eToro. You can find see my portfolio here and if you are not yet on eToro, consider using my referral link to join.
Foundational facts
The foundational facts of the theory I present are simple and hardly surprising and yet most people fail to see the impact they produce in combination. Here are the basic facts,
Most people investing in stock markets earn well above their needs. They are investing their spare cash. These people are not immediately affected by inflation and pandemics. They don’t need the cash immediately.
Investments move between 3 most common asset classes which are real estate, government bonds and stock markets. This is para-phrased from Harry Markowitz’s seminal work on Portfolio Theory. Other than these investments, the people with spare money spend on leisure and luxury.
A quick primer on Government Bonds
I have found that most people don’t understand government bonds and what affects their prices, even though they are fairly simple. Let me explain it in easy words real quickly.
Governments issue bonds to raise money for things like public infrastructure development and offers to pay an interest to the people that buy them. These are regarded as safest investments. The bonds have a nominal value, this is the amount the government will repay at maturity. But they are sold at a discount, ie. a bond with nominal value of $100 will be sold at something like $97. In addition the bearer of the bonds gets interest payments at fixed rate, also called coupon. The bonds are transferrable and are traded on an exchange.
Collectively, the gains from the difference between the discount price at which you buy the bond and nominal price and the interest payments gives the Yield to Maturity (YTM), or more commonly referred to as yield.
Now government bonds become attractive when the interest rate is supposed to go down in future. Bonds can ensure a higher fixed return than bank deposits. More people want to buy bonds so bond price goes up and yields fall.
If the interest rate is supposed to go up in future, people holding bonds are at a disadvantage because they could get higher returns elsewhere, so they want to sell their bonds and bond prices fall, which means yields go up.
That explains why government bonds reached a peak yield of 4.9% in 2023 with rising interest rates.
Back to the topic
Now with this background consider the 3 scenarios I have listed above.
In 2021, when COVID first hit, people started moving out of cities. There was uncertainty in the market and real estate was worst hit. Expenditure in leisure and luxury was low. Interest rates were already at rock bottom, and government was in expansionary phase, so interest rate weren’t going to rise, so bond yields were low. That means most of the money flowed into stocks.
In 2022, COVID was coming to end, governments worried about inflation and started raising interest rates gradually. Instead of reducing spending this created a mad rush in real estate. People were buying in anticipation that interest rate will be higher next month. Expenditure in leisure and luxury grew tremendously. Money started moving to these other avenues and we saw bond yields go up and stock prices fall.
2023 started with interest rates at 4.5%, up from 0.25% in a year. The real estate market cooled down. With 4% higher interest rates, EMIs are more than double for the same loan and term. Demand for luxury items like cars also dropped. Interest rates were expected to go up and stay high for a long time, so bonds became less attractive and yields continued to rise. So, stocks once again became a popular investment choice.
What does this mean for 2024?
The US Fed has suggested that interest rates should start to drop by May of 2024. I however expect this to be delayed. By the end of 2024, I expect real estate investment to start picking up. Bonds will start to become more attractive as interest rates start to fall. Demand for luxury items such as cars should also pick up as it becomes cheaper to borrow money. This means money should move away from stocks by the end of 2024.
This is just one of the many factors that affects the movement of money but with the government playing a heavy hand in controlling the flow of money in the last few years this has been a key contributor to the trends we’ve seen and will continue to see in the coming couple of years.
There is certainly a lot to be said about the effect of AI and the productivity boom it promises on the stock market, but that is a topic for another post.
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Thank you for reading!