Put The Stock Market In Perspective

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I want to explain how to put things into perspective as far as the stock market is concerned. In another article I will then explain how to try and predict the mid-run stock market movements.

The major booms and crashes on the stock market (just as those on the real estate market, on the oil market, on the gold market, on the foreign exchange and on other markets) are the repercussions of the cheap money policy of the Federal Reserve Bank.

It all boils down to one thing: the dollar losing value against other commodities/currencies during the boom and the dollar regaining value against them in the recession.

The federal reserve tries to foster business activity by injecting additional credit into the loan market. Interest rates drop in the short term. Credit becomes cheap. Entrepreneurs embark upon projects which they usually wouldn't touch. The factors of production they need to purchase are financed by cheap credit. They would have usually been employed for other projects which fulfill more urgent needs of consumers.

In the wake of these events, investors also obtain cheap credit and channel it into other markets, such as the stock market, the real estate market, the commodities and gold market, they invest in oil futures and oil prices rise.

It is important to understand that this is all one chain of interconneced events. Contrary to common media claims, it is utterly wrong to believe that a drop in oil prices id good for the stock market and vice versa. The oil prices themselves do not affect the stock market. It is the cheap credit that causes the rise on both these markets. History has shown us that oil prices, gold prices, real estate prices and the stock market movements are strongly correlated.

The rise in prices results in a premium that lenders apply after some period in order to account for the principal and interest payments' loss in value. Loans become more expensive again. The Federal Reserver now steps in in order to rectify its previous mistake of unnecessarily exuberant credit expansion. Government officials start realizing that commodity prices are rising at an uncomfortably high pace. The FED tries to curb credit expansion by selling bonds and hence withdrawing credit from the market. It increases the dicount rate.

But inflation still lingers on. Entrepreneurs keep investing time and toil into their projects. Investors on the stock market are still convinced that prices will keep rising. As it is with human nature, once a significant amount of money has been invested, men are always prone to stay the course as long as they see a slight chance of success.

The FED keeps trying to curb the excessive credit expansion. This goes on until investors start realizing that government bonds now provide a much higher and safer yield than their commodity and business investments. The inevitable happens, the stock market crashes, housing prices drop, gold prices drop. Malinvestments are cleared. Unprofitable projects are put on hold or completely discarded.

Prices drop. Necessarily wage rates would also have to drop in order to adjust to the new state of affairs and to ensure full employment. However, wage rates are rigid downwards. Governments have imposed minimum wage restrictions in order to appeal to the workers which are the majority of people. Some employers can't afford to pay the wages required by government decree. Hence, unemployment ensues.

The FED heroically steps in and again injects cheap credit. The cycle begins anew.