EXCLUSIVE: Why Are Markets Up BIG If the Economy Sucks? – a Quick Hit with Economist Editor Greg Ip

One of the most frequently asked questions is how markets continue to rally in the face of a global economy filled with land mines. I caught up with Greg Ip – The Economist U.S. Economics Editor and author of The Little Book of Economics — to get some answers …

Damien Hoffman: Greg, based on the economic principles you cover in your book, can you explain why the S&P 500 (NYSE:SPY) is up over 95% while the media keeps saying the economy sucks?

Greg Ip: Well one reason it’s up so much, of course, is it had fallen so much to start with. Remember: even having gone up 95% it has still not made back all of the losses it suffered at the depth of the crisis.

As I explained in my book, the stock market is not necessarily telling us what investors see out there in the economy today, but where they think it’s going based on what’s happened to interest rates, inflation, growth, spending, as well as the stability of our banks (NYSE:XLF) and the rest of our financial system.

At the depth of the crisis in 2008 and early 2009, things really looked dire. There was some possibility we were going to fall into another depression. So, investors had to price that possibility into the level of stocks.

We now know we did not go into another depression. So part of the rally the removal of that risk from investor’s calculations.

Second, in the last six months the outlook for the economy has genuinely improved. You have to make a distinction between the current state of the economy and it’s direction. Yes, unemployment is still high, but it’s going down. The direction or trend matters a lot because it is what influences investor sentiment.

Currently, the direction is generally positive. GDP rose at a 3% annual rate in the 4th quarter. Jobs are being created at a painfully slow rate, but they are being created.

We’ve also seen consumer spending revive. It’s important to keep in mind that unlike previous recessions, the last one was caused by a financial crisis and a collapse in credit. Banks (NYSE:XLF), having sustained big losses, are less able or willing to lend. Borrowers either can’t borrow because they can’t meet the tighter underwriting standards of banks or their assets, like their homes, are worth less. Or, they won’t borrow because they want to save since their wealth has been devastated.

So, this sort of recovery tends to be slow and painful because we have all these people trying to work down the debts they accumulated during the boom years. However, that process doesn’t have to hold back the economy forever. People don’t have to stop saving and paying down debt, they have to do it at only a slightly less frantic pace, and that frees up cash to spend which is what we are seeing now.

Returning to markets: the stock market is very much a forecasting machine and it thinks the future will be better than the present.

If the stock market is right — and as I pointed out in my book it does have a habit of sending us a lot of wrong signals — this would be a good year for the economy.

Greg Ip is The Economist U.S. Economics Editor and author of The Little Book of Economics.

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