Thursday, June 08, 2006

What's Happening to Stocks?

The Dow Jones Industrial Average closed below the 11,000 threshold for the first time in three month yesterday, June 7, when it hit 10,930.90. According to many in the news business, the drop is due to continued adjustments to bad news about inflation and the U.S. economy after Mr. Bernanke's speech, echoed yesterday by Atlanta FRB President Jack Guynn. Fears of inflation, and forthcoming interest rates increases by the Fed, the story goes, will slow down the economy, and that is driving down stocks (see for example today's commentary of wednesday's markets in the WSJ).

There is something wrong with this analysis. First, as low inflation promotes economic stability and long run performance, investors should greet positively actions taken by the Fed to curb inflation: further rate rises, if needed, would only benefit the economy. So stocks should react positively.

Second, is it really fear of inflation that is driving markets down? How have bonds reacted? Long term bond yields have barely changed in the last two days. The 10-yr note yield closed at 5.02%, and even the three month T-bill closed at 4.81% on monday, from Friday's 4.80%, and at 4.85% yesterday.

So, if we are to find something in Mr. Bernanke's speech that has shaken the markets, what is it? I think stock markets reacted, rationally, to his clear economic analysis of the current state of aggregate supply ---read my previous blog about the analysis. Mr. Bernanke said that there is little doubt that the economy is approaching full capacity utilization, and although productivity will continue to grow, it is unlikely that it will continue to do so at the pace we have observed in the last few years.

If stock prices before the announcement were based on longer lasting sustained growth of the kind we have experienced so far, then adjustment of growth expectations can very well explain the drop in prices. Stock prices are taking Mr. Bernanke's analysis seriously. Now, Mr. Bernanke's warning that we maybe seeing a growth slowdown soon does not mean that the economy is about to experience bad times. It just means that growth may be stabilizing closer to long run levels experienced by the U.S. (think 3% rather than 4% or more). This seems hardly bad news. So it's possible that stock markets did overreact by taking the analysis more negatively than intended by the Fed Chairman. Here I am just speculating though.

One final thought about inflation. With the economy stabilizing at a lower growth rate, it is natural that money supply should grow less rapidly, otherwise there would be to many dollar bills chasing to few goods to buy, which would spur inflation. Thus the need to raise rates a little. It seems investors should be confident about future Fed policy, as bond traders seem to be showing.

What's your take?

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