Robert Samuelson agreed to be a punching bag again this morning. His column expressed his concern that the stock market and bond market are going in opposite directions. While the stock market has been rising, which in his view is supposed to mean a stronger economy, interest rates in the bond market have been falling which is supposed to mean a weaker economy.

There are two major flaws in Samuelson's conundrum story. The first is that the stock market is a horrible indicator of the future. Remember when the market plunged back in 2006 giving us advance warning of the economic disaster that would follow from the collapse of the housing bubble? Oh right, the market rose through 2007 and hit a new nominal high in late October of that year, just over a month before the beginning of the recession.

And of course there was the crash in 1987 that foretold of the ensuing recession that didn't happen, or at least not for another two and a half years (after the market had fully recovered). Given the weak relationship between the market's performance and the future state of the economy, it is difficult to believe that anyone would look to the former as predictor of the latter.

The other point is that even in theory the stock market is not supposed to be a predictor of the economy. The stock market is supposed to represent the present value of future profits. In recent years the profit share of output has been extraordinarily high. A likely reason for the surge in profit shares is the weakness of the labor market. If the economy were to get stronger the unemployment rate would fall to more normal levels. This would increase workers' bargaining power and likely lead to a drop in profit shares. This means that if traders in stock anticipated stronger growth, it could be associated with a drop in stock prices since the decline in profit shares would more than offset the higher profits associated with higher GDP.

In short there is no reason, either based on past evidence or in economic theory, that higher stock prices should be taken as implying stronger economic growth. This is another great non-conundrum to keep economic policy types in Washington employed.

 

 

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