Anyone else have that strange feeling a tsunami heading our way while we’re idling on the beach? A discussion on the relation between the financial markets and the real economy.
The image seems fitting. The earthquake caused by the stock markets in the heart of the financial ocean will most likely unleash a tsunami that will rage all over the real economy. We’ve all witnesses the impact the credit crunch has on the financial markets. What’s in store for us as far as the real economy goes?
Stock prices are supposed to reflect the values of companies. The value of companies is derived by their cash flow producing ability and the risk involved. If the value of a stock is greatly depreciated than we must assume either the risk of doing business is much higher or the cash flows to be generated are much lower (or both).
Lower cash flows and higher risk assume, in turn, that the economic environment is less supportive of the company’s activities either in lower demand for the company’s products or a higher cost of doing business (finance and credit) due to risk.
This crisis is a bit different but it will eventually portray the same symptoms of any other recessions. The combined effects of a “credit crunch” and a huge liquidity shortage will eventually take their toll on companies. Credit is the oil in the market’s motors. Without credit there really can’t be any market activity.
Some of the very essence of business is the magic of using debt to generate value. Hardly any company has enough equity to do business. All companies borrow, simply because their business enables them to generate value over the cost of the money borrowed.
In the current crisis the cost of credit has risen dramatically for two main reasons:
- The loss of trust in the markets – No one feels able enough to estimate the risk inherent in a certain company and as such cannot properly estimate and price the credit given. Financial institutions seem to prefer not to lend at all.
- The lack of liquidity – These go hand in hand as the lack of liquidity forces each company to carefully consider who they conduct business with and who gets they cash leaving them with credit lines.
As a result the risk of doing business is dramatically enhanced thus effecting stock prices. Some companies may be very vulnerable to this phenomenon as they’ve leveraged themselves greatly with debt or operate under very low margin making their lives much harder.
When people have less money they tend to spend less. This is a general rule the US has been able to side-step so far but it seems those days are gone, for now. We have less money when:
- We have less money – a tautology indeed. When people lose capital they have less money.
- We think they have less money – Even more important is how people perceive their financial situation.
Today all of us have less money and we also think we have less, both on a current and future basis. Most of us will probably tighten up our belts and closely monitor out outgoing cash flows. What economists call private consumption will take a hit and with it many companies who thrive on our shopping.
This will naturally have an impact on financial results of many companies further fueling the stock market crash.
From a Financial Crisis to a Real Crisis
The beauty of it is we’ve only just begun. The stock market, being what it is, supposedly already factors in all I’ve talked about and assumes both cash flows and risks have taken a turn for the worse assuming what I’ve written above will most probably happen.
All that is left is for us, and the economy, to play our small parts in the game. It’s rather troubling when you think about it this way. Fate is already determined. Much like the tragedy of Oedipus who was prophesized to kill his father the king so are we marching on the path to recession.
Take a look at the following graph which details the lagged relation of unemployment and the stock market for a good example:
(I’ve found this chart in an interesting post @ Disciplined Approach to Investing)