The only stock tip you will ever need: Watch the Dow

The Dow Jones Industrial Average (DJIA), America’s premier stock market index, has been quoting at all-time-high levels. On 7 March 2013, it closed at 14,329.49 points. This has happened in an environment where the American economy and corporate profitability has been down in the dumps.

The Indian stock markets too are less than 10 percent away from their all-time peaks even though the economy will barely grow at 5 percent this year.

[caption id=“attachment_653091” align=“alignleft” width=“380”] All the easy money created by the Federal Reserve is landing up in the stock market. So the stock market is going up because there is too much money chasing stocks. Reuters[/caption]

More from Investing

MSMEs are breaking the traditional convention. Look who’s funding them Scale-up your startup without an investor! Here’s how

In this scenario, should one dump stocks or buy them?

The short answer is simple: as long as the other markets are doing fine, we will do fine too. The Indian market’s performance is more closely linked to the fortunes of other stock markets than to Indian economic performance.

So watch the world and then invest in the Sensex or Nifty. You can’t normally go wrong on this.

Let’s see how the connection between the real economy and the stock market has broken down after the Lehman crisis.

The accompanying chart below proves a part of the point I am trying to make. It tells us that the total liabilities of the American government are huge and currently stand at 541 percent of GDP. The American GDP is around $15 trillion. Hence the total liability of the American government comes to around $81 trillion (541 percent of $15 trillion).

[caption id=“attachment_653081” align=“alignleft” width=“600”] Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013[/caption]

The total liability of any government includes not only the debt that it currently owes to others but also amounts that it will have to pay out in the days to come and is currently not budgeting for.

Allow me to explain. As economist Laurence Kotlikoff wrote in a column in July last year, “The 78 million-strong baby boom generation is starting to retire in droves. On average, each retiring boomer can expect to receive roughly $35,000, adjusted for inflation, in Social Security, Medicare, and Medicaid benefits. Multiply $35,000 by 78 million pairs of outstretched hands and you get close to $3 trillion per year in costs.”

The $3trillion per year that the American government needs to pay its citizens in the years to come will not come out of thin air. In order to pay out that money, the government needs to start investing that money now. And that is not happening. Hence, this potential liability in the years to come is said to be unfunded. But it’s a liability nonetheless. It is an amount that the American government will owe to its citizens. Hence, it needs to be included while calculating the overall liability of the American government.

So the total liabilities of the American government come to around $81 trillion. The annual world GDP is around $60 trillion. This should give you, dear reader, some sense of the enormity of the number that we are talking about.

And that’s just one part of the American economic story. In the three months ending December 2012, the American GDP shrank by 0.1 percent. The “U3” measure of unemployment in January 2013 stood at 7.9 percent of the labour force. There are various ways in which the Bureau of Labour Standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is the U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.

U6 is the broadest definition of unemployment and includes workers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers”, or people who have stopped looking for work because economic conditions make them believe that no work is available for them. This number for January, 2013, stood at 14.4 percent.

The business conditions are also deteriorating. As Michael Lombardi of Profit Confidential recently wrote, “As for business conditions, they appear bright only if you look at the stock market. In reality, they are deteriorating in the US economy. For the first quarter of 2013, the expectations of corporate earnings of companies in the S&P 500 have turned negative.Corporate earnings were negative in the third quarter of 2012, too.”

The average American consumer is not doing well either. “Consumer spending, hands down the biggest contributor of economic growth in the US economy, looks to be tumbling. In January, the disposable income of households in the US economy, after taking into consideration inflation and taxes, dropped four percent-the biggest single-month drop in 20 years!,” writes Lombardi.

Consumption makes up for nearly 70 percent of the American GDP. And when the American consumer is in the mess that he is where is the question of economic growth returning?

So why is the stock market rallying then? A stock market ultimately needs to reflect the prevailing business and economic conditions, which is clearly not the case currently.

The answer lies in all the money that is being printed by the Federal Reserve of the United States, the American central bank. Currently, the Federal Reserve prints $85 billion every month, in a bid to keep long-term interest rates on hold and get the American consumer to borrow again. The size of its balance-sheet has touched nearly $3 trillion. It was at around $800 billion at the start of the financial crisis in September 2008.

As Lombardi puts it, “When trillions of dollars in paper money are created out of thin air and interest rates are simultaneously reduced to zero, where else would investors put their money?”

All the easy money created by the Federal Reserve is landing up in the stock market.

So the stock market is going up because there is too much money chasing stocks. The broader point is that the stock markets have little to do with the overall state of economy and business.

This is something that Aswath Damodaran, valuation guru, and professor at the Columbia University in New York, seemed to agree with, when I asked him in a recent interview about how strong is the link between economic growth and stock markets? “It is getting weaker and weaker every year,” he had replied.

This holds even in the context of the stock market in India. The economy which was growing at more than 8 percent per year is now barely growing at 5 percent per year. Inflation is high at 10 percent. Borrowing rates are higher than that. When it comes to fiscal deficit we are placed 148 out of the 150 emerging markets in the world. This means only two countries have a higher fiscal deficit as a percentage of their GDP, in comparison to India. Our inflation rank is around 118-119 out of the 150 emerging markets.

More and more Indian corporates are investing abroad rather than in India (Source: This discussion featuring Morgan Stanley’s Ruchir Sharma and the Chief Economic Advisor to the government Raghuram Rajan on NDTV). But despite all these negatives, the BSE Sensex, India’s premier stock market index, is only a few percentage points away from its all-time high level.

Sharma, Managing Director and head of the Emerging Markets Equity team at Morgan Stanley Investment Management, had a very interesting point to make. He used the following slide to show how closely the Indian stock market was related to the other emerging markets of the world.

[caption id=“attachment_653093” align=“aligncenter” width=“560”] India’s premier stock market index, is only a few percentage points away from its all-time high level.[/caption]

As he put it, “It has a correlation of more than 0.9. It is the most highly correlated stock market in the entire world with the emerging market averages.”

So we might like to think that we are different but we are not. “We love to make local noises about how will the market react pre-budget/post-budget and so on, but the big picture is this. What drives a stock market in the short term, medium term and long term is how the other stock markets are doing,” said Sharma. So if the other stock markets are going up, so does the stock market in India and vice versa.

In fact, one can even broaden the argument here. The state of the American stock market also has a huge impact on how the other stock markets around the world perform. So as long as the Federal Reserve keeps printing money, the Dow will keep doing well. And this in turn will have a positive impact on other markets around the world.

To conclude let me quote Lombardi of Profit Confidential again “I believe the longer the Federal Reserve continues with its quantitative easing and easy monetary policy, the bigger the eventual problem is going to be. Consider this: what happens to the Dow Jones Industrial Average when the Fed stops printing paper money, stops purchasing US bonds, and starts to raise interest rates? The opposite of a rising stock market is what happens.”

But the moral is this: when the world booms, India too booms. Keep your fingers crossed if the boom is lowered some time in the future.

Vivek Kaul is a writer. He tweets @kaul_vivek