Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Does the Stock Market Really Ruin the Economy?

Wednesday, February 10, 2016


Last week’s Wall Street Journal (2/1/2016) featured an article (Does the Economy Ruin the Stock Market Or Does the Stock Market Ruin the Economy, gated) citing recent work by UCLA economist Roger Farmer questioning whether the recent market rout simply reflects the economy, or whether a weak stock market is crashing the economy. After summarizing the conventional perspective that discounted future earnings determine market pricing, the article conceded that maybe, just maybe, stock market patterns could be influencing the real economy. Our reaction? What took you so long?! We’ve been making that case for more than thirty-five years.

Of course, stock prices are the mathematical result of expected cashflows discounted at the Cost of Capital (COC). But that Cost of Capital isn’t some static metric determined by long-term averages and fixed formulas. COC changes continuously, reflecting investor assessments of expected inflation, taxes, risk, global capital flows, and other tangible and intangible factors (animal spirits, anyone?). It’s not the perfect inverse of stock price, since cashflow and earnings expectations keep changing as well, but for any given level of expected earnings, a strong market reflects a low COC and a weakening market reflects a rising COC.

So how does this relate to the real economy? Virtually every publicly traded firm is a bundle of projects, some expected to earn high returns, and others expected to earn borderline returns. When prices are strong and Cost of Capital is low, present value arithmetic provides the incentive for firms to take on more and more of these borderline projects, since they create shareholder value by doing so. But when the Cost of Capital rises the value of these borderline projects turns negative, they are more likely to get rejected, with the ultimate result being that the firm’s growth slows substantially. Add up all the firms in the country, and the result is a dramatically weakening economy.

This doesn’t happen instantaneously, of course. Companies can’t and shouldn’t adjust their long-term investment plans every time the market hiccups; these short-term blips are appropriately shrugged off.   Moreover, many firms don’t have a clear understanding of the relationship between stock price and COC, relying on static models like the Capital Asset Pricing Model (CAPM) that incorporate very long-term averages as inputs. So it’s no surprise if they respond more slowly to equity market signals than they would to an equivalent change in interest rates. But even these firms ratchet back their investment programs once their stock price has fallen enough, particularly if the board and large investors start to lose confidence.

We’re not academics or professional macroeconomists, so we’re not going to pick apart the specific numbers or forecasts cited in the Wall Street Journal article. Our Chief Compliance Officer also reminds me that this post is a statement of opinion, and not a factual forecast. Having said that, our perspective is that Farmer’s assessment is generally on target: Falling stock prices do influence the real economy, particularly when such a trend is sustained. And even though our analysis has generally focused on the investment side of the equation, Farmer’s assessment of consumption decisions certainly sounds plausible. We won’t comment on the various market interventions he proposes except to reiterate our own view that tax policy, particularly taxes on investments, has a substantial impact on COC.

There’s no question that today’s global economy faces risks on multiple fronts, so of course the markets are going to respond. At the same time, it’s only prudent to monitor cost of capital trends, and to at least consider when and where policy changes or other interventions are warranted.


  1. Hi Dennis,
    I completely agree with your perspective. The idea that the stock market is merely a reflection of the economy is just another academic idealization, an unjustified one. For sure, the stock market influences the economy in many ways. For once, changing equity prices change the capital structure of a firm, with repercussion on, e.g., the ability to borrow and other capital operations. Also, there are nontrivial behavioral effects. For example, companies are quick to cut costs and buyback shares when they see a hint of decreasing stock prices. This is due not necessarily to rational economics, but but also to the simple fact that CEOs pay is strongly linked to stock performance. (In fact, share buybacks turn out to be largely inefficient due to bad timing). The list goes on.
    Interestingly, the smallest impact is probably what the Fed though would be the most important, namely the wealth effect.
    All of these observations point to simple common sense: with due respect to Prof. Farmer, he has indeed discovered the obvious.

  2. Right on! It is kind of a dance of the devil! I suspect that tax policy is probably more important than most realize, witness the huge amounts of corporate cash held outside the US because of tax policy to say nothing about the trend to incorporate in low tax countries.

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