What, then, do short-run profits say about the overall economy? Not too much, as it turns out, and certainly nothing consistent. Stock prices depend on profits, and in the short run, profits are determined by lots of things. Consumer buying power, government buying power, international trade and Federal Reserve and government policy actions all affect profits. In 2008 the stock markets corrected dramatically in response to fears of an impending financial market collapse. This made sense, because a well-functioning financial system is necessary for profitability. Government intervened with stimulus spending, and the Federal Reserve boosted the money supply, reducing interest rates in a bid to stabilize the economy. This calmed the profit fears and the stock market recovered a bit.
Since 2009 we have seen a slow and painful climb back to higher stock prices. Today we are likely in a recession; taxes have just increased and government spending looks to get a big cut in a few weeks. Eight million more folks are looking for work than in 2007, and consumers are not buying like they were in those pre-recession salad days.
Still, stocks thrive. How can that be? Demand for goods is indeed dampened in the wake of the recession. So too are the costs of production. Profits are a function of both revenues and costs, and so a leaner, more productive business can be highly profitable even when the overall economy languishes. Even with the negative grow in the fourth quarter, the U.S. produced more goods and services in 2012 than in any year in history.
We are just doing so with far fewer workers. This shedding of 8 million unneeded workers boosted profits for lots of businesses, but there is more to the story of stock prices than this.
Our Federal Reserve and government policy makers rightly laud higher stock prices. But labor markets, not stocks, focus policy action. A weak economy means more stimulus, and more stimulus means more short-run profits. So, for Wall Street we have the best of all worlds, and so stocks rise. Not so for Main Street and the millions of workers who have been passed by in this recovery.