Hi Larry,

My name is Russ and I’m an undergraduate majoring in economics. I have been following your Smart Money Reports for a few months now and each week look forward to your keen insight as to the direction of the markets. As I have been continuing to learn I usually walk the fence when it comes to taking market sides, but recent trends have left a burning question in my mind concerning your latest report.

I understand that the markets can stay irrational for a long time, but I wonder if the latest bull move we've been experiencing is irrational given the continuous trend in positive economic data. During those periods of bear market decline that you cited in American history, was any reliable economic data available? I ask because it would be one thing if we were in a bear market rally given poor economic indicators, but indicators I have seen and that you quote seems to be progressively positive. Are investors at this time truly acting irrational? I suppose the answer to my question lies within the historic economic data of those periods in our history in which we were in bear markets. People sure seem to enjoy buying the news, and right now the news seems positive. Can one blame them? What are your thoughts?

Russ,

The stock market as it relates to the economy. I could write a book on that subject. But given the constraints of a message board, I’ll just point out a couple of things to consider.

First of all, the stock market doesn’t affect the economy nearly as much as the economy affects the stock market. However, it is not a simple matter of saying, “Well, the economy is doing well, so I think I’ll buy stocks.” Or, “The economy stinks so I think I’ll sell.” The stock market discounts news far in advance. For example, this current bear market rally (some would say it is a new bull market but reasonable minds can differ) began in October of 2002. Economic data was generally bad then. But market participants were looking months down the road. So selling started to dry up and buying started to occur. In turns out that those who bought were correct because now good economic numbers are coming out (I think they’re overblown, but again reasonable minds can differ). So what is left for all of those buyers to do? They can either hold on to their stocks or they can sell. The only justification to hold on would be if they think that even better economic numbers are going to come out several months from now. So at some point, like maybe now, market participants begin to sell even though good economic numbers continue to be reported. That’s why historically the best time to buy is when things looks the worst and the best time to sell is when everything looks wonderful.

It’s also an oversimplification to assume a good economy is going to mean a healthy stock market. What is the meaning of a good economy to the stock market? It means that corporate earnings will improve, right? That’s well and good, but how much should we pay for those earnings? 10 times earnings? 20 times earnings? 30 times earnings? How do we value how much a stock is worth?

So at the end of the day it is all about the psychology of investors. More than anything else the market is driven by emotions. Two specific emotions – greed and fear. I think it is useful to think of the stock market as like a beauty contest. You’re one of the judges of this beauty contest. Except, unlike a real beauty contest, with this contest you’re trying to figure out what all the other judges are thinking about the relative beauty of the contestants. If you can do that you can know who is going to win the contest. And the longer you participate in the market, the more you realize that it’s all about trying to figure out what other market participants are thinking and doing – not what the government is telling us about durable goods orders or whatever.

If you want to understand the stock market, Russ, while you’re in college take a few psychology courses along with your economic courses. Also, if there is a good course in market history, make sure you take that as well.

Larry

Hi Larry,

Thank you very much for your thoughts as to the stock market. I think I now have a much better understanding as to what is driving the current market. You do a fine job of breaking things down to be easily understood, something many teachers struggle with.

I have been studying economics hoping that being equipped with a better understanding as to how the world markets function, I will be able to achieve success as an investor. I look forward to continually recieving your reports as they have been a valuable asset in complementing my education in college. Thanks for your advice!