Can stock markets grow continuously?

Stock markets have been a hot topic in the media space for the past few weeks. The Dow Jones Industrial Average posted its biggest one-day drop since 2008 at the beginning of the month, down 5.2% to 24,190.90 points. The S&P 500 also ended the first week of February down 5.2%, while the Nasdaq closed the week down 5.1%. The situation in Europe was similar. The pan-European Stoxx 600 fell 4.2%, while the German DAX finished the week at 12,107.48 points, down 5.5%.

The situation was similar on the French and English stock exchanges. Concerns that the end of cheap money is very close, fears of a resumption of inflation and speculation about the possible need for central banks to tighten monetary policy are causing many investors to rethink their attitude.

Prices during a growing economy tend to fall, not rise.

The stock market doesn't work the way most people think. The common belief is that a stock market boom is a reflection of a growing economy: as the economy grows, companies generate more money and the value of their shares increases in line with the increase in their intrinsic value. The basic assumption underlying this belief is that consumption is the engine of economic growth.

A stock market decline is therefore caused by a decline in consumption – due to inflation, rising oil prices, high interest rates, or no reason at all – which leads to lower business profits and higher unemployment. Whatever the supposed cause, a weakening economy leads to a decline in corporate revenues and lower-than-expected future earnings, which leads to a decline in stock prices. This understanding of the markets is technically correct, superficially considered, but it is misconceived because it is based on faulty financial and economic theories.

In fact, the only real force that ultimately drives the stock market or any other market to grow over the long term is the amount of money in the economy. Stocks rise when there is money supply inflation (i.e. more money in the economy and in the markets).

The main culprit for rising prices

The general price level can only increase if the amount of money in the economy increases faster than the amount of goods and services. In countries experiencing an economic downturn, prices can rise when the supply of goods and services falls, while at the same time the money supply remains the same or even increases.

When the supply of goods and services grows faster than the supply of money—as it did for most of the 19th century in the United States—the unit price of each good or service falls. George Reisman provides us with a formula for calculating prices in an economy [1]. In the formula, price (P) is determined by demand (D) divided by supply (S). The formula tells us that it is mathematically impossible for aggregate prices to rise in any way other than (1) an increase in demand or (2) a decrease in supply; that is, either by more money being spent on goods or fewer goods and services being sold in the economy. The same formula can be applied to the prices of assets—stocks, bonds, houses, oil, etc. As another Austrian School economist wrote:

“It is impossible for the profits of most companies to increase without an increase in the money supply (either by creating new credit or spending savings)” [2]

Returning to the stock market, it is now clear that the market cannot grow continuously, not without the creation of new credit. There are other ways in which the market can grow, but these are temporary. For example, an increase in net savings, involving less spending on consumer goods and more investment in the stock market (which leads to lower prices of consumer goods). The same is true for a reduction in tax rates. This would be a temporary effect. The only source of continuous growth in any market is newly created bank credit.

The relationship between the economy and the stock market

The basic relationship between the stock market and the economy as a whole is that an increase in the money supply stimulates both GDP and the stock market. A growing economy is one in which more goods and services are produced over time. Real wealth is not money, but the goods and services produced. The more refrigerators, computers, cars, food, clothes, medicines, etc. we have, the richer we are. As we have already seen, if goods are produced faster than money, prices will fall.

With a constant money supply, wages will remain the same as prices fall because the supply of goods will increase, but the supply of workers will not. If productivity increases, goods will become cheaper in real terms. It is obvious, therefore, that in a growing economy the price level will fall. Regardless of the quantity of goods and services in an economy, if the money supply is constant, the only money that can be spent in the economy is that which exists.

This in itself reveals that GDP doesn’t tell us much about the number of goods and services actually produced; it only tells us that its growth is due to the money supply, since an increase in GDP is mathematically possible only if the price of the individual goods produced increases by some amount. Otherwise, with a constant money supply, the total value of the revenues that companies earn – the total value of all goods produced – and GDP itself will necessarily remain the same year after year.

If the inflation rate is high enough, used car prices would rise like new cars, but at a slower rate. Applied to the stock market, if the money supply is constant, the total amount of all stocks (stock index) cannot rise. Furthermore, if the company's profits have not increased, there will be no increase in earnings per share (EPS).

In an economy where the money supply is constant, stock market levels will remain approximately constant. And, in general, businesses will sell a larger volume of goods at lower prices, and their total revenues will remain the same. Also, businesses will generally buy more goods at lower prices, preserving the difference between revenues and costs, which will maintain the availability of profits. Under these circumstances, capital gains (profits from buying low and selling high) can only be realized through active portfolio investment - by investing in companies that are expanding their market share, offering new products to the market, etc., thereby generating proportionally more revenues and profits at the expense of those companies that are less innovative and efficient. Since the average value of companies' shares will not increase, most of the profits will be in the form of dividends.

Forced investment

Since we have already seen that neither the stock market nor GDP can grow without an increase in the money supply, we can now clearly see that a growing economy consists of neither a growing GDP nor a growing stock market. This is not to say that there is no relationship between the profits generated by companies and their stock market value in today's inflationary times, but that the parameters of this relationship - profit ratios and market capitalization as a percentage of GDP - are quite flexible and change over time.

The price of stocks, houses, gold, etc. does not rise; it simply holds its value better than that of paper money because its supply does not increase as rapidly. If there were not so much money printed by governments and banks, goods would become cheaper over time and we would not need as much money for retirement. But we are now forced to invest to maintain our purchasing power in this modern era of monetary and price inflation. To the extent that some of us even come close to success, we have still pushed further, accumulating our “profits.”

The entire inflation system is solely for the purpose of stealing and redistributing wealth. In a world without government printing presses and wealth taxes, the armies of investment advisors, pension fund administrators, estate planners, lawyers, and accountants associated with us who help us plan for the future would not exist. These people would instead be employed in other industries producing goods and services that would actually increase our standard of living.

Money supply increases profit margin

Newly printed money from the central bank largely affects variables such as profit, revenue, and cash flow. For example, when the government creates new money and injects it into the economy, this new money increases companies’ sales revenue before its corresponding expenses, thus increasing profit margins. Much of the corresponding expenses associated with the new revenue lag behind in time due to accounting procedures such as spreading the cost of an asset over its useful life (depreciation) and delaying the recognition of inventory costs until the product is sold (cost of goods sold). This delays the recognition of expenses in the income statement. Because these expenses are recognized in a company’s income statement months or years after they are actually incurred, inflation reduces their value at the time of recognition.

For example, a company recognizes an expense of $1 million for equipment purchased in 2009. That $1 million is worth less today than it was in 2009; however, in the statement, the corresponding revenue is in today's purchasing power. With the continuous increase in the money supply, the amount of revenue is always greater than the amount of expense because most of the expenses were incurred in the past when there was less money available. The huge amount of money printed in response to the Great Recession is what generates the good profit levels that companies are currently reporting. With each subsequent printing of money, the profit margin increases; it also increases with increased inflation. This is one reason why companies in countries with high inflation rates have such high profit levels.

Another factor is that there is a relative lack of capital in a relatively poor and underdeveloped country. Also, the newly printed money is the main reason for the positive changes in leading economic indicators such as industrial production, consumer durables spending, and retail sales. These are growing based on new money demand, not due to a resumption of real economic growth.

The final example of how the money supply fundamentally affects the economy is interest rates. When interest rates fall, discounting future expected cash flows at the lower interest rates (using the DCF model) the expectation is that the stock market should rise because future cash flows and earnings are valued higher. The help needed to lift the market is due to the fact that when interest rates are lowered, the central bank creates new money that enters the loanable funds markets. This increases the supply of the latter and thus lowers interest rates.

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[1] Вж. Reisman, George, Capitalism: A Treatise on Economics (1996), p.897 [2] Machlup, Fritz, The Stock Market, Credit, and Capital Formation (1940), p. 90.