Stock Prices: S&P 500

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The following perspective is excerpted from a paper titled “When Do Stock Market Booms Occur?” It was written by Michael D. Bordo and David C. Wheelock of the Research Division of the Federal Reserve Bank of St. Louis. It is part of the St. Louis Feds’ monthly Working Paper series and was published in September 2006. In it they discuss some of the causes of the boom and bust cycle of equity markets:

“Most studies of the relationship between asset booms and macroeconomic conditions focus on the consequences of booms and, especially, of market crashes for macroeconomic activity. Several draw lessons for policy from crash experiences. Recent examples include Bordo (2003), Mishkin and White (2003), and Helbling and Terrones (2004). Bordo (2003) finds that many, but by no means all U.S. and British stock market crashes of the 19th and 20th Centuries were followed by recessions. A serious decline in economic activity was more likely, he concludes, if a crash was accompanied or followed by a banking panic. Mishkin and White (2003) come to a similar conclusion in their review of U.S. stock market crashes in the 20th Century. They find that a severe economic downturn was more likely to follow a crash if the crash was accompanied by a widening of interest rate credit spreads. The key lesson for policy, Mishkin and White (2003) argue, is that policymakers should focus on the financial instability that can arise in the wake of crashes, rather than on crashes per se.

“Helbling and Terrones (2004) examine median output growth across major stock market booms and busts of 1970-2001 and find that busts often preceded sharp slowdowns in economic activity. Echoing an observation of Bordo’s (2003) about U.S. and British crashes of the 19th and early 20th Centuries, Helbling and Terrones (2004) find that busts typically coincided with or followed a tightening of monetary conditions. Whereas numerous studies explore the effects of stock market crashes, relatively few examine the conditions under which stock market booms arise or persist. In a prior paper (Bordo and Wheelock, 2004), we examined episodes of unusually rapid growth of U.S. nominal stock prices during the 19th and 20th Centuries. We found that many such episodes occurred when real output and productivity growth (both labor productivity and total factor productivity) were unusually rapid, suggesting that stock prices were at least partly justified by macroeconomic conditions. By contrast, we found no consistent relationship between the growth of nominal stock prices and inflation, but noted that inflation was usually low and stable during periods of rapid growth in real stock prices. Here we explore in more depth the macroeconomic conditions under which stock market booms have occurred in the United States and nine other developed countries. In so doing, we hope to obtain insights about the macroeconomic conditions and policies that seem to foster booms, and whether experiences differ across countries.”

http://research.stlouisfed.org/wp/2006/2006-051.pdf

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The following is excerpted from a feature on the website of the Federal Reserve Bank of San Francisco called “Dr. Econ”. Readers ask economic questions of “Dr. Econ”. A reader asked the following question: “Which stock market indictors may be used to measure market performance? What causes bull and bear markets?” The answer excerpted below describes the S&P500 in relation to other market indices as well as an overview of “Bull” and “Bear” markets:

“[T]here are many stock market indexes that one can use to monitor or evaluate the performance of the overall market or a sector of the market. While all the market indexes are influenced by present and expected macroeconomic conditions, including interest rates, corporate earnings, business cycles, and inflation, the different indexes may exhibit strikingly different performance characteristics.

“A narrowly focused index, the Dow tracks the economic health and earnings outlook for the stocks of 30 blue chip industrial companies (there are separate indexes for transportation firms and utilities). In contrast, the Standard and Poor’s 500 Common Stock index (S&P 500) is a broader measure, a weighted index of the stock prices of 500 large U.S. firms, and its performance reflects conditions across a broad mix of industries. The NASDAQ composite index is dominated by high-tech firms, and its performance reflects economic conditions and the outlook for the high-tech sector.

“The S&P 500 is classified as a leading economic indicator by The Conference Board and is used in their calculation of the composite leading economic indicator series. This designation recognizes that the S&P 500 typically rises (falls) several months before the overall economy begins to expand (contract). This is a tendency, not a rule; the economy continued to expand following the 1987 stock market crash.”

http://www.frbsf.org/education/activities/drecon/2001/0102.html

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The following perspective is excerpted from a speech by Federal Reserve Governor Susan Schmidt Bies at Canisius College in Buffalo, New York on April 18, 2005. In it she discusses retirement savings and how the next generation of workers will be more dependent on personal savings than previous generations, many of whom had work-funded pension plans to depend on upon retirement:

"Another concern relates to the way employees manage their 401(k) plans. Some participants simply invest contributions equally across the investment options or according to plan defaults, which in many cases is a low-risk, low-return money market fund. And, as has been publicized widely in recent years, many 401(k) participants invest heavily in employer stock. Among companies that offer company stock as an investment option, more than one-quarter of 401(k) balances are in company stock. This high concentration cannot be attributed entirely to an employer match that is required to be held in company stock. Instead, employees appear to voluntarily purchase and hold abundant amounts of company stock, despite the obvious risk of linking their current income and retirement wealth to the financial health of their employer.

These patterns are troubling because they raise doubts about the financial security of workers in later life. Fortunately, new research in the discipline of behavioral finance provides some important insights into the behavior of 401(k) participants and suggests some promising changes that can lead workers to make savings choices that will leave them better prepared for retirement. Contrary to predictions of traditional finance theory, the way the retirement-plan options are framed affects the choices made by participants. Researchers have found that "opt-out" plans--those that automatically enroll workers unless they actively choose not to enroll--have substantially higher participation rates than plans in which employees must take the initiative to opt in. Moreover, when defaults are designated, many workers tend to enroll using the default contribution rates and investment options and to leave these in place for many years after enrollment, even though the default may be set too low to allow for the accumulation of sufficient retirement assets.

If workers are influenced by how choices are offered, then employers can make changes to the plans to help participants make better decisions. For example, employers might set default contribution rates to rise as workers receive pay raises, or set the default investment option to a diversified portfolio that adjusts as the worker ages. In addition, employees have increasingly expressed interest in employer-provided financial education, and firms and lawmakers are responding. Congress has passed legislation that makes it easier for firms to provide investment advice with less fear of being held liable should such advice lead to losses. Some firms have started to provide access to a third-party who will advise employees about how much to contribute and how to invest their contributions. Moreover, a recent study by the Employee Benefit Research Institute (EBRI) suggests that education about retirement planning provided by employers led to a substantial portion of employees altering their retirement savings.

In closing, as credit availability and financial alternatives continue to expand, it has become ever-more important for consumers to develop the skills necessary to make informed financial choices. I encourage prospective graduates to place the same priority and attention to managing their personal finances as they do to developing their careers. Beginning early and remaining committed to thoughtful management of personal finances throughout one's life is an essential element to long-term financial success."

http://www.federalreserve.gov/boarddocs/speeches/2005/20050418/default.htm

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The following is an excerpted from a speech given by Federal Reserve Vice Chairman Roger W. Ferguson Jr. to the National Bankers Association in Nashville, Tennessee on October 6, 2004. In it he discusses how stock prices not only reflect productivity and corporate profitability, but also have a speculative component that is not always consistent with economic reality:

"...for many households the operative concept of saving is not the portion of current income that they do not spend but rather the change in their net worth. The former measures only the acquisition cost of new household assets whereas the latter measures the change in the market value of assets, which is the acquisition cost of new assets plus the capital gain or loss on existing assets. The latter measure of saving does indeed paint a far more positive picture of household saving behavior: The ratio of the change in net worth to disposable income, although more volatile over the past decade than previously, has been essentially trendless over the past two decades. Whether or not we should take comfort from this alternative picture of the saving rate is a complicated issue, one that is inextricably tied to our confidence that the price of corporate equity accurately reflects the underlying productivity of corporate assets. One would expect that capital gains on financial or real capital assets reflect a positive reassessment of the productivity of some physical asset and, therefore, an increase in the potential for greater future consumption. To this extent, capital gains serve the same function as saving out of current income. But, it is hard to believe that all the movements in asset prices witnessed in recent years are well-rooted in changes to the underlying productivity of those assets. A telling reason for skepticism is the behavior of stock prices since the late 1990s. What information on productivity or productivity growth can account for, first, the near-tripling of share prices during the late 1990s and, then, the retrenchment of prices in 2000 and 2001? It would appear that a portion of past swings in net worth has reflected behavior based on something other than well-founded assessments of changes in the underlying productive potential of existing capital. Nevertheless, on the issue of why the personal saving rate has fallen, empirical evidence linking the stock of wealth to consumption spending supports the view that capital gains on corporate equities and residential real estate have been important factors."

http://www.federalreserve.gov/boarddocs/speeches/2004/20041006/default.htm

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