The Hindu Business Line : The economy-stock market divergence

The last several weeks have seen a disconnect between US economic data, energy, commodity and food prices on the one hand, and stock prices on the other.

In fact, despite the severe woes of the economy and credit markets, the Dow Jones Industrial Average, at its worst, was just about 15 per cent off its peak, compared to emerging economies’ stock indices which fell 25 per cent and more.

The reason for the resilience of US stocks could be the market’s assessment that there will be no recession (or any setback will be short-lived).

That might be a case of hope trumping reality. For, although the Fed has brought down rates to just 2 per cent from 5.25 per cent in rapid fire succession and also injected several hundreds of billions of dollars of liquidity against non-Treasury collateral, inter-bank interest rates remain well over the Fed’s benchmark and T-bill yields.

This suggests market players still do not trust one another.

As for lending, a recent survey found a significant tightening of credit standards and margin and collateral requirements in banks and financial institutions. Without credit, whither the US economy, one might well ask.

Strong headwinds

Obviously there are strong headwinds in the form of rising energy prices and the housing crisis.

The portents on the latter front are gloomy. Influential voices say the worst is over for banks, but not for the average homeowner. House prices have still some way to fall. It is difficult to see how consumer spending would hold up when this is happening.

After all most of household wealth is in the value of personal dwellings.

And banks will continue to be reluctant lenders till house prices look up and their confidence in collateral values improves. Not to talk of jobs and incomes being hit in the slowdown.

The situation is inevitably heading for government intervention. It may not even await a new President.

A reluctant President Mr George Bush may have to be dragged into signing and implementing reliefs for the worst affected homeowners much as his father was forced to do through the Resolution Trust Corporation during the crisis that hit Savings and Loans Associations in the late eighties and nineties.

Stock market

Could the stock market stand aloof from the economy? For that, one must believe that the financial and employment difficulties of the millions of average American households do not matter at all.

(There are, of course, always, mergers, amalgamations and corporate takeovers, ostensibly to create more shareholder value, which put a floor on how far prices can fall even in a poor economic environment).

The conclusion must be that a sustained stock rally depends on an end to rising energy prices and falling house prices, restoring discretionary income to the consumer and normalcy to credit markets.