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Question! Did We Learn an Important Lesson About the Stock Market?

Question! Did We Learn an Important Lesson About the Stock Market?

Financial Consulate’s phones seem to ring off the hook in response to a change in the political atmosphere. The individuals who call depend on who is elected and their political beliefs. Twelve years ago, callers were worried that if President Obama were elected, he would (fill in the blank), destroying the economy; then four years ago, callers were worried that if President Trump were elected, he would (fill in the blank) and destroy the economy. Now, callers have the same fears regarding President Biden. Questions and conceptual discussions about selling stocks before a change in political power are quite common. Despite current worries of what a political change, combined with an unprecedented objection to the transfer may do, the stock market has climbed higher. But why is this, and were there signs that the fears would not become reality?

One of the most challenging concepts to understand about markets is that they are forward-looking and do not often react to today’s reality. This is one reason why financial journalists who frequently write, “Today the market is up or down because (fill in the blank)” are not credible to a professional investor. The exception would be if something completely unexpected happened one day, but that is very rare.   For example, in May 2001 the S&P 500 was at 1291.96 at its height, and on September 10, 2001 it was at 1092.54.  When the market opened the week after September 11, 2001, it dropped to 965.80 and then proceeded to climb higher.  You see, the market was reacting to signs by declining up to three months before it happened.  In 1991, when President Bush sent troops into Iraq to overturn Saddam Hussein, it was the day the markets turned upward.  As markets had been declining for months in advance because of the fear of an invasion, it was likely the markets had already discounted most of the risk.  Therefore, the day of the anticipated invasion was the day of the turn.

In the event you do hear about a risk that you think could devastate the market, evaluating how widely known this theory is makes for a good first step. If plenty of other people are saying the same thing, then chances are, the market will have already evaluated and discounted the concept well before it happens. Therefore, when people call and say, “We need to sell stocks, because…” or, “Are you shifting your investments, because…” our typical response is, “NO, the market already knows that.” Presidents and political parties can talk about how their actions may impact the economy or country, but business just takes what they are doing and figures out how to incorporate any political action for their benefit or least potential detriment. Politicians are not the key issue driving markets.

The driver of markets is liquidity, and the federal reserve banks of the world control liquidity.  The federal reserve banks are the main influence of up and down stock markets.  Liquidity is the cash available in the economy: the ability of businesses and individuals to borrow, and the banks’ willingness to lend to businesses and individuals. Liquidity drives markets, and if liquidity increases, markets are likely to go higher. A way to illustrate this concept is to picture a balloon expanding as it receives a continuous flow of air. If the air intake pauses, the balloon expansion pauses. The balloon contracts if air is released. This image depicts what the federal reserve banks do to an economy. Some may say, “But if the government borrows money, then they are adding air to the economy.” This is true, but a country’s federal reserve is the key to how easily its government borrows. No U.S. President can expand borrowing without the Federal Reserve accommodating this government request for liquidity.

It is for these reasons that Financial Consulate does not panic in the midst of political changes, but instead, focuses on the Federal Reserve and the momentum of the stock market.