Question/Comment: What’s up with the stock market? I thought it was supposed to be a leading indicator of economic conditions. But over the last months, the market seems to respond more to interest rate levels in addition to insignificant economic news rather than to the gathering credit crunch, inflation risk and housing mess. Can we have a bull market and a bear market in different sectors at the same time?
Paul Solman: So let me get this straight, Connor. You think I know what’s up with the stock market? And still work for public TV? OK, get ready for a long answer. For what it’s worth (not much), here’s one basic way to look at the market’s overall price. At any given moment, it’s the value of all the future profits of the companies in it. That’s because when you buy a share in an S&P 500 index fund, say, you buy a tiny, tiny sliver of, roughly speaking, America’s top 500 companies. What are they worth collectively? You might think it’s their cash on hand, minus what they owe, plus what they can get for their buildings and machines – their “net worth,” in other words. But if they stop doing business, those machines might be almost worthless. A company’s value comes from lots of intangibles, not just the stuff it can lay claim to.
Ultimately, then, companies are profit generators – or at least they’re supposed to be. They’re worth whatever money the company can generate. Roughly, that is, their profits — which add up over time. To finally answer your question: yes, the market should be a leading indicator of future prosperity.
So why then does the market tend to go down when interest rates go up and vice versa? Several reasons. One is that when interest rates go down, those future profits are worth more today.
Think about it. You run a Mike’s Hard Lemonade stand and expect to earn $10 in profits this year, $10 next year, $10 for the next 10 years. What’s the stand worth right now? Or – another way of putting it – what might you or I be willing to pay for it? What should one pay for an income stream of $10 a year for a decade? $10 per year times 10 years. How about $100? Doesn’t seem too unfair, right? Pay $100, get $100.
But wait. Suppose interest rates are 5 percent a year. Then you could buy a bond paying 5 percent a year, which just means you’d lend someone the money at a 5 percent interest rate. So you’d get $5 a year for 10 years, plus your $100 back at the end. Your total payback? (Do the numbers before I tell you.) $150, right?