Why Stocks Go Up Despite Economic and Political Uncertainty

Daniel Penzing
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It seems counter intuitive, but sometimes Wall Street ignores the latest news reports. Here's why.

One of the most perplexing things in finance is how the market can rise when everything seems to be going wrong. Whether politics and economics are particularly unstable, if a new stock or a new mutual fund has gone bad or if bad economic reports are released, sometimes the stock market goes up.

How can this happen? If it’s a really down day, why is the stock market going up?

The answer lies in how stock markets work. The market isn’t made up of a bunch of different giant companies that all move in a similar way every day. These huge companies have earnings, valuation and momentum, essentially the same as the other companies in their sector. Smaller companies, maybe 100 or 200 that are considered “small caps” are much more like the start-ups of a sector and behave much differently. Because of the way that people behave with stocks, they are often counterintuitive in a good way.

People are not investing for logical reasons.

The stock market is not just one huge machine that each company has to be moving in the same direction at the same time. It is a collection of huge and small companies and each individual company can do whatever it wants. Owners of these companies can think of reasons why the stock should go up or go down, and they can interpret the news differently than you or I.

The Buildup

As the 1920s began, the United States was about to embark on an economic boom that would last for years. While the decade was marred with one of the worst economic depressions in the history of the country, the early years were far more cheery.

In 1927, the United States had passed the 18th amendment to its constitution, which prohibited the sale, manufacture, and transportation of alcohol. This caused demand for alcohol to plummet and sent thousands of people out of work.

In response, Congress passed the first federal minimum-wage law and the Revenue Act of 1928, which instituted a graduated income tax. These policies created greater economic equality; wages rose, and lower classes had more money to spend on goods and services.

By 1929, the nation was ready to burst, and business was booming. In spite of a few stock market crashes, the economy had its best year in 1929, with an unemployment rate of just 3 percent. With the brain trust of J.P. Morgan, Sr., Joseph Kennedy, and Bernard Baruch counseling the government, and with the country’s new sophisticated consumer base, the people who had money in the stock market saw that it was time to invest.

Why Markets Go Higher

Despite Economic and Political Uncertainty?

It was just a few years ago that the world was gripped by the financial crisis. In 2008, the banking industry was hit with staggering losses; millions lost their jobs; and financial markets around the world tumbled, leaving most countries in a financial quagmire that has taken years to escape.

Did this experience leave an indelible mark on the world financial markets?

Yes, it did, at least that was the overwhelming response from Yale SOM’s latest student survey. A whopping 96% of the students said that that the financial crisis had changed the way that they view their financial futures. In fact, 92% said the crisis made them more cautious about their finances and 83% say that the crisis has changed their career choices because it has made them more risk averse.

So what is the lesson in this that can be learned from a finance and investing perspective?

That the world not only has been transformed by the financial crisis but that financial markets have been changed forever as well. One thing is for sure, the vast majority of investors in the world will never again place the same amount of trust in the banking or financial sectors as they did in the past.

Economic Instability

We all have heard that the equities market moves in accordance with the interest rates.

I believe that there are two reasons for this observation. First, bond investors get rewarded for taking risks during unstable times. And second, many people think that an unstable economy is an indication of an unstable market. The truth is that both of these arguments are invalid.

Why are stocks a better investment during times of market instability?

Let us understand by an example.

Assume that an investor buys an equity at Rs 100 while the interest rate is 6%. The simple equation for calculating the holding period return is:

Holding Period Return = (Rs 100 x (1+6%)) / 100 = Rs 106

Now, if the same investor uses the same amount and invests it in a debt instrument which offers 9%, his return will be:

Holding Period Return = (Rs 100 x (1+9%)) / 100 = Rs 109

Now, consider 3 scenarios:

1- Equity prices do not move in a particular year.

2- The equity price appreciates by 20% in a particular year.

3- The equity price falls by 20% in a particular year.

It is clear that the second and third scenarios have lesser value movement. For the second scenario (price appreciation), the holding period return is higher.

What's an Investor to Do?

The U.S. stock market has hit record highs recently, even with continued economic uncertainty in Europe and political unrest around the world. Experts can't really say for sure why stocks keep rising, but here are a few ideas about why stocks are going up despite uncertainty:

Global Inflation: The U.S. stock market is struggling to grow, so investors are keeping an eye out on the rest of the world. In countries like China and India, economic growth is happening significantly faster than in the U.S. Plus, those countries have updated technology and infrastructure and more educated workforces, so they have a higher potential for growth.

Politicians: One reason that stocks keep going up is that the European Central Bank hasn't yet kicked Greece out of the euro, which could potentially undermine the value of the entire currency. Two reasons why politicians are holding back on a departure: 1) it's risky, and 2) it would upset foreign markets.

Central Banks: In response to fears of global instability (including the ongoing euro crisis), most major central banks are keeping their interest rates low. That way, investors have a safe place to park their money when they're afraid to take risks with stocks.