The Rise of the Stock Market

Sanjay Paul
March 1996

A version of this article appeared in March 1996, Business Forum, Green Bay Press-Gazette.

On Friday, March 8, the stock market fell sharply. Dow Down 171 Points, screamed the headlines, sending investors scurrying nervously to the financial pages. Saturday and Sunday were filled with agony, suspense, and a sense of imminent doom. The markets opened on Monday, and investors held their breath. Would this be a repeat of Black Monday, that fateful day in October 1987 when the Dow Jones Industrial Average lost 508 points?

As it turned out, it wasn't. On Monday, the stock market rebounded smartly. Investors let out a collective sigh of relief. And over the next few days, the stock market settled down to its usual pattern of moderate ups and downs.

What gives? Was Friday a harbinger of unpleasant tidings? Or was it a mere blip, an aberration, that doesn't merit much attention?

Over the last few months, the performance of the U.S. stock market has been nothing short of spectacular. In 1995, the Dow rose over 30%, and while it has showed some signs of fatigue lately, the Dow has continued to set records this year as well.

The impressive rise in the Dow has been accompanied by furious speculation about its future prospects. One school of thought, drawing on historical parallels, warns of impending doom. Evoking images of tulipomania (a trading frenzy in tulip bulbs - no less! - in Holland in the 17th century which landed many ordinary folks in trouble) and the Roaring '20s (a period which witnessed a dizzying ascent in the U.S. stock market only to see it end in the great crash - and equally great depression - of the 1930s), some view the recent breathtaking rise in share prices as a sign of imminent trouble. In their view, the Friday plunge was only the first of its kind. Get out, they say, before the market crashes for good.

Others, of a more sanguine nature, argue that things are different this time. There are safeguards in place, they assert, that will prevent similar occurrences this time around. They point, for instance, to the Federal Reserve's role in 1987 - by quickly injecting liquidity into the financial system in the aftermath of the October stock market crash, the Fed is widely credited with having prevented an economic catastrophe. Stay in the stock market, this school of thought advises, and enjoy the ride.

What is the individual investor to do? Get out - or stay in?

In order to answer the question, we need to take a closer look at stock prices. The prices of shares - or indeed any asset - are determined by the expected returns on the asset. An investor buys shares in the hope of receiving dividends during the period of ownership, and selling the shares for a profit at the end of the period. Since there is uncertainty about both these events - for they occur in the future - investors must make their decisions based on expectations about the future.

Now, in understanding how expectations are formed, the importance of investor psychology cannot be gainsaid - indeed, periods of frenzied speculation arise because of misplaced enthusiasm about the near-term prospects for a certain asset. In the nascent Russian stock market, for example, a short-lived period of unbridled speculation in a certain stock ended with its value plummeting to zero - with disastrous consequences for the hapless investors who were left holding the worthless shares.

In most cases, however, it is largely the prevailing economic environment that drives expectations about future corporate earnings and thus share prices. When the economic conditions are propitious, companies prosper - as do their shareholders. When the economy falters, corporate earnings are threatened - adversely affecting stock prices.

What do the tea leaves have to say about our economic prospects in the near future? While the rise in the gross domestic product during Clinton's presidency has been indubitably good for the stock market, economic growth has begun to slow of late. As evidence of a weakening economy begins to mount, concerns about reduced corporate profits have begun to emerge. This is likely to temper the rise in share prices. However, one must note, the economic fundamentals (low interest rates, rising GDP, low inflation) that have propelled the stock market to its record highs have not disappeared - they have just become slightly weaker.

Barring some unforeseen circumstance - such as a sharp hike in inflation, or political upheaval in the Middle East - the stock market will continue to wend its way upward, albeit in a more leisurely manner. There will be hiccups along the way - as Friday's drop showed - but the trend is clearly upward. So, coming back to our question - should one get out or stay in? - the answer must be: Stay in the stock market. And keep a watchful eye on the economy.

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