While over the last several months, the stock market has done quite well, most recognize that the economy may not be as healthy as the stock market seems to indicate. I wanted to take the opportunity to explain why the economy is a long way from getting back to “normal” and what government stimulus efforts are attempting to do.
Let’s start with a basic equation of economic theory:
So, the amount of money in the system times the velocity, or how quickly and often it is used, equals the price level times economic output. This is not a frequently used equation these days and the theory from which it comes has its detractors (1) or critics, but I think it can be used to look at what’s going on currently. But hang on for a moment and I will break down even further what this equation has to do with our current situation.
As a result of COVID-19, economic activity basically stopped in the spring. People stayed home. Cultural opportunities closed. Meals were mostly cooked at home. Young adults went back to living with their parents. We all recognized that we were headed into a recession, or perhaps a depression. But why?
Simply, it was not that we didn’t want to spend money. We did. People who didn’t lose their incomes changed how they spent, not whether they spent. Instead of going to the movies, we bought Netflix. Instead of going to the supermarket, we used Amazon Fresh. Instead of going to ball games, we bought toilet paper and yeast. The pullback had to do with reacting to excess risk in the system, but it was not economic in nature; it was about health and imposed by governmental policy (even though many people had pulled back on their own spending in the face of the new risks). All this meant was that V, the velocity of money, dropped hastily. This means that some combination of P and Y dropped as well to balance it out. To some, this may look like a “chicken and the egg” question. Which dropped first, the left side (MV), or the right side (PY)? Here it seems clear that it was the V dropping causing the others to respond.
When V drops (one of the great ironies of this is that when I learned it, V was modeled to be a constant value) (2), prices, output, or some combination of the two must drop to make the equation work. If prices drop (deflation), the results can be very destructive and result in a “deflationary spiral.” (3) As a result, in the face of declining velocity, the Federal Reserve moved to increase money supply by lowering interest rates and buying financial assets. According to the economic theory that gives us our equation, an increase in the money supply should increase prices and/or output.
One of the components of Y is “investment” (the others are consumption, which was down, and government spending, which went up through stimulus). Clearly, with the excess money around from the Federal Reserve, the money had to go into an investment because money was not able to be used for consumption—travel, personal care, or cultural events—either because of our own apprehension at participating in those activities or because many of those activities are closed or have restrictions placed on them. Hence, we are seeing money go into markets in part because there are fewer places for the money to be used.
As a result of this “extra” money being used for investment in the market, the market has gotten a boost that is not necessarily reflective of the rest of the economy.
While I cannot predict the future, my best guess is that as restrictions are lifted and/or we are able to have our full complement of spending options, we will shift some of our money from “investment” to “consumption” and market prices will more likely reflect real economic conditions. Whether that is higher or lower than current market values or there are higher or lower prices and money supply, I can’t tell you. My hope is that this article might help explain some of the disconnect you might feel about why the economy stinks while stocks are at all-time highs.
1. https://www.pragcap.com/the-mvpy-myth/
2. https://www.investopedia.com/terms/v/velocity.asp
3. http://investopedia.com/terms/d/deflationary-spiral.asp
Russell D. Rivera, CFA, CFP® is the Founder and President of Voice Wealth Management (Voice) in New York, NY. He also likes to think of himself as a Personal CFO and Financial “Therapist” for entrepreneurs, young professionals, and their families. He helps clients make prudent financial decisions regarding spending, saving, investing, and planning while giving a voice to the individual client's financial priorities and experiences.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.