The stock market is not the economy – don’t get ruffled by its fall

What we are witnessing could be a natural correction – one popular explanation for the sharp sell-offs in equity markets in recent days among analysts is that it is actually a response to the strength of the US and global economy

Another explanation is that US financial markets, and to some extent those of the rest of the world, have been in the grip of irrational euphoria for some time (Getty/iStock)

Live by the stock market boast, perish by the stock market boast. “The stock market has smashed one record after another, gaining $8 trillion in value,” Donald Trump bragged in his State of the Union address only last week. “That is great news for Americans’ retirement, pension and college savings accounts.”

And now, with the US stock market down more than 6 per cent in just two days of trading? With around $1.6 trillion (£1.1 trillion) wiped off the value of US companies since Friday? What does that mean for the savings of ordinary Americans? What does that say about the economic prowess of the President of the United States who has presided over the drop? Where are the tweets from the braggart-in-chief?

Nemesis has followed hubris for Trump, at least when it comes to the stock market. And how richly deserved it is. Yet this is, sadly, no morality play. Trump’s learning curve is our world. And it’s not just in the US were stock markets are sharply down. Some $4 trillion has been shed from equity markets around the world in the past week. So what do these market sell-offs mean for the global economy? What do they mean for all of us?

The first thing to do is to appreciate something that was apparently beyond Trump: that the stock market is not the economy. Stock markets can boom when GDP is stagnant, when wages are flat, when living standards are going nowhere. And they can fall when economies are picking up speed and life, for many people, is getting better. The latter actually describes the current situation.

Indeed, one popular explanation for the sharp sell-offs in equity markets in recent days among analysts is that it is actually a response to the strength of the US and global economy. There was a tentative sign last week that US average wages, after more than a decade of weakness, might finally be creeping back up to the rates of growth seen before the global financial crisis and the great recession.

The implication of that, so the logic goes, is that the US central bank, the Federal Reserve, will have to put up interest rates faster in order to stop the domestic economy overheating and inflation getting out of hand. Lower interest rates automatically boost the prices of financial assets, including stocks and shares, so higher interests should have the opposite impact. So what we are witnessing is a natural correction. And because the US economy is still the world’s largest and because the US dollar is the global economy’s “reserve” currency what happens there is impacting on financial markets everywhere.

Perhaps. Another explanation is that US financial markets, and to some extent those of the rest of the world, have been in the grip of irrational euphoria for some time. One often-cited gauge of the value of US markets, which compares large companies’ earnings to their stock price, suggests they are more overvalued than at any time except before the turn-of-the-millennium internet stock slump and the Wall Street Crash of 1929. Another much-watched general market volatility index is spiking too.

That could suggest what we are seeing is not so much a natural, short-term, correction, but the bursting of a bubble. In other words, there could be much more to come.

So which is it? The answer is that it’s impossible to say with any confidence. And the people who claim they know with certainty really don’t. What we can say is that even if a stock market bubble is in the process of popping, that does not imply that the real economy – whether in the US, the UK or anywhere else – is set to implode too. It does not necessarily mean we are heading into another recession, where companies go bankrupt and people lose their jobs.

Equity markets have slumped before without causing a recession, most obviously after the internet bubble burst in 2000. The FTSE 100 fell more than 50 per cent in the following years, but there was no recession in the UK.

More recently, the Chinese stock market in 2015 dropped more than 40 per cent in months but its domestic economy was largely unruffled. In 1987 US stock markets plunged by more than 20 per cent in a single day – Black Monday – but there was no discernible impact on the real economy. The large stock market drops in 2008-09 coincided with the global financial crisis, but they were not the cause of the crisis itself. Responsibility for that genuine economic disaster lay with the fragility of the global banking system.

Equity markets do matter for ordinary people. But they matter in entirely different ways than Trump thinks and many commentators imply. The performance of the companies in an index matters for ordinary people over the long term. That’s because the stock of companies is a repository for peoples’ savings. And most people are not saving for tomorrow, or next week, but for decades in the future.

Public markets also matter because large listed firms in most countries tend to be major employers, significant sources of private investment and productivity-enhancing innovation. It’s important that the companies within them are subject to sensible regulation, feel competitive market pressures, have good corporate governance, that they invest for the future and that the right financial incentives act on their managers. All those factors should concern us deeply.

But the short-term ups and downs in stock prices are largely meaningless – except, of course, if you’re a speculator or a monumentally hubristic politician.