Stock Market Rebounds -- Does That Mean U.S. Economy is OK?

Today stock markets rebounded after suffering last week from the worst losses in years:

• Dow Jones Industrial Average - up 157 points (1.3%), after dropping more than 600 points from its all-time high of 12,786 on February 20
• S&P 500 - up 21 points (1.5%), after falling 80 points from its high of 1,453 on February 15
• NASDAQ - up 44 points (1.9%), percent after losing 7% since its high of 2,524 on February 22.

Does this mean everything is now OK with the U.S. economy? Not necessarily. For one thing, the stock market reflects investors' beliefs about the future value of corporate earnings. If investors think earnings will go up, they will pay more for a share of stock, which is a piece of that corporation. Corporate earnings depend on the overall U.S. economy. Therefore, the stock market is an indicator of investors’ beliefs about the state of the economy. Some experts say the stock market is actually a leading indicator of about six months out.

However, the stock market is also dependent on investors’ beliefs about other investment alternatives, including foreign stock exchanges. In this case, the sudden 8.4% drop in China’s Shanghai index caused a global panic, as investors sought to cover their losses. A big cause of sudden market swings is the unknown effects of derivatives, which allow speculators to borrow money to buy and sell large amounts of stocks. Thanks to these speculators, markets can decline suddenly, as happened last week.

For these reasons, sudden swings in the U.S. stock market can occur that are no reflection on the U.S. economy. In fact, today's market upswing occurred despite several reports released today that indicated the U.S. economy is doing more poorly than expected. (See “Productivity is Less than Estimated, and Pay Is Higher,” New York Times, March 7, 2007).

Bottom line? Expect further swings in the stock markets over the next several months, and (as said previously in this blog) pay close attention to economic indicators to judge the state of the U.S. economy.