Just because the stock market goes up, don’t assume that the economy is in good shape. If the economy is struggling and the stock market is soaring, it could be a signal that the stock market is heading into bubble territory.
During 2005 to 2007, the housing bubble led to the expansion of low-quality debt (such as subprime mortgages) issued by government-sponsored enterprises (GSEs) such as the Federal National Mortgage Association (FNMA, or “Fannie Mae”). This low-quality debt was packaged as securities and sold to many Wall Street brokerage firms and financial institutions. Because the ultimate payers of these securities were actually borrowers who didn’t have the financial strength to make payments on this debt, defaults occurred on a massive scale, and the securities became worthless. This, in turn, meant that the brokerage firms and financial institutions incurred massive losses, and they needed to replenish these losses by selling what assets they had, such as stocks. Stocks were sold en masse to cover these losses and keep many financial institutions from going out of business.
The public data clearly showed that the skyrocketing levels of debt were too large and definitely unsustainable. When I saw this coming, I told my investing readers and students to avoid debt and the general stock market and especially to avoid stocks of brokerage firms and financial institutions. For those who were speculators, put options on housing stocks and financial industry stocks (such as those of brokerage firms and mortgage companies) were profitable moves.
Due to the historic convulsions that occurred at the time of the market crash of 2008, the Fed started intervening in the stock market, which impaired the traditional relationship between the stock market and the economy. In 2009, the stock market hit rock bottom and then soared from 6,547 (March 2009) to over 18,000 (early 2015), which is an increase of nearly 200 percent. However, the economy has had an anemic recovery from the 2008 recessionary low, and the GDP of the United States grew in low single-digit percentages.
During this time, the Fed bought stocks through its member banks to boost the stock market. However, this wasn’t a good idea because a central bank such as the Fed can artificially stimulate a market when it pumps up the market with money (more money buying more stocks), which leads to an asset bubble that, in turn, can grow into a dangerous bubble. However, the economy itself needed repair — not the stock market. When the economy is good and thriving, the financial condition of companies improves, which then makes them attractive for stock investors.
