Clinton political advisor James Carville famously uttered the phrase “It’s the economy, stupid” over 30 years ago. As they say, the rest is history. Mr. Carville correctly predicted that the recession under the first Bush would help get his candidate elected.

Yet, as time passes, systems evolve. So, where Carville’s analysis and prophetic utterance of the obvious in the 1990s was dead on for that time, in the present, his conclusion is less applicable to the economic landscape. That’s because in contrast to the past where the economy and the stock market were less dependent on each other, in the present they have become a single system. In addition, it’s now the economy that reflects the stock market.

How Did We Get Here?

It took decades for the extent of globalization to be fully evident. But by the time COVID hit in 2020, the trend had been established and the pandemic exposed the weaknesses of the system.

Consider the following. Since the late 1980s-early 1990s:

• Manufacturing, and many services jobs such as call centers, left the U.S. to China, Asia, and other areas of the under developed world as companies searched for higher profits primarily due to lower labor and related costs;
• The U.S. became a financialized economy where technology and fee generation replaced the macro income streams traditionally garnered from manufacturing;
• The Federal Reserve kept interest rates at lower levels than in other periods in history as the lower costs from external manufacturing kept prices down and inflation low;
• Low interest rates fueled a rise in debt levels both corporate and personal as low debt is more easily serviced; and
• Supply chains became just in time mechanisms based on the ease of low-cost manufacturing and easy to manage cost effective global shipping.

When COVID hit and the global economy ground to a halt, the Federal Reserve turned on the money spigots, global governments cranked up the stimulus packages and the economy eventually picked right back up again.

Except, for one thing; China’s extended and intermittent shutdowns along with regional U.S. and European shutdowns and related pandemic related changes in population dynamics revealed that there was a new set of problems:

• Huge amounts of money in circulation from both fiscal policy and central banks;
• Increased demand for goods and
• Significant reductions in manufacturing and transportation capacity.

The result was rampant inflation because demand never slowed but suddenly because just in time inventory management and globalization were not prepared for the secular changes in manufacturing capacity in developed nations, a significant deficit on the supply side of the economy was exposed.

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The Fed’s excessive money creation gets the blame for the inflation, but that’s only part of the problem. Excessive fiscal policy shoulders some of the blame too. But the real culprit are the limitations that were present in the supply side of the system due to the secular changes in production and manufacturing that emerged from globalization

It All Changed in 1990

The graph below shows compares the growth of the S&P 500 (SPX) earnings to GDP. I use this illustration because the general trend of earnings for SPX is closely correlated to the general trend in stock prices.

Source: investmodels.com

Note that until the early 1970s, the GDP and stock prices marched in lock step. By the late 1970s, GDP and stock prices essentially decoupled with GDP rising and stocks remaining stagnant. Those were the days when Carville was right on the money. It was all about the economy.

After 1990, there emerged a close correlation between GDP growth and the trend for the S & P 500’s earnings and price trend. Much of this was due to the effect of the Fed’s steady increasing in money supply after the 1987 crash in stocks. Moreover, this is when the Fed’s trend toward easy money after each recession became the dominant influence in the economy via the stock market.

The Fed lowered interest rates and printed money (quietly) after each recession which followed the 1987 stock market crash. Much of that money remained in circulation even during tightening cycles that followed. The net effect was that each time the Fed eased, they were in effect easing rates from a higher point in the money supply chain.

That steady money printing, each building on the previous easing cycle, led to higher stock prices, which in turn created the wealth effect which led to a nearly continuous rise in GDP.

This new closeness between stocks and the real economy was especially noticeable in 2000, when the Internet bubble burst, and in 2007 when the subprime mortgage crisis led to the Great Recession. By 2020, the melding of the stock market and the economy were complete, as the Fed’s printing presses hit an all time record and the stock market responded, with GDP quickly following.

The Stock Market’s Role

As globalization proceeded, speeding up after 1990, the global economy changed drastically resulting in stagnant wages in the West where a significant portion of the population, not able to find work in traditional areas such as manufacturing became dependent on government assistance, part time work, or just plain off the books activity for income.

Still another section of the public, whose wages were also stagnant but who were still employed and through their 401k or equivalent plan, became dependent on the wealth effect created by the Fed’s low interest rates and its subsequent boost of the stock market, which was partially fueled higher by companies buying back their own shares, often via low interest rate loans.

As long as interest rates remained low and the stock market remained buoyant, the whole system could work indefinitely.

When money gets tight, stocks eventually crash and the economy weakens.

The MELA System

So, while in Carville’s time, it was indeed the economy, because of globalization, just in time inventories, and artificially low interest rates for decades, the stock market is now the major driver of economic activity.

I call it the MELA System where M is for markets, E is for the economy, L is for life decisions, and A is for artificial intelligence (algos), whose presence is ubiquitous through the highly automated and financialized economy of the developed world.

Here is a summary of how it works:

• Rising markets increase the value of 401k plans, IRAs, trading accounts and crypto holdings;
• Based on the value of these accounts, people make financial decisions, such as buying cars and houses, or taking big vacations and;
• The algos that trade stocks, compile data which affects all financial decisions, and decide who gets a loan based on, you guessed it, those 401k plans and IRAs, etc. influence the economic trends make everything happen faster.

The whole thing, however, is based on the stock market and its influence on the “wealth” that resides in stock market related accounts. Moreover, as I stated earlier, everything is perfect as long as every cog in the system is in tune with the rest of the system.

The Fed Broke the System

Unfortunately, the Federal Reserve has broken, or at least severely damaged the system. By raising interest rates it has caused a stock market crash. That means that all of the wealth tied to the stock market, including 401k plans, IRAs, trading and crypto accounts has been significantly reduced.

In addition, the wealth accumulated by corporations, pension plans, and even some governments which quietly invest in stocks via their sovereign wealth funds is now significantly reduced as well along with their earnings power for the future as consumers tighten their belts in response to their “wealth” declining from the stock market crash.

Moreover, the Fed continues to remove $95 billion from the financial system every month. That’s money that’s no longer available for big money institutions to buy stocks as they are now focused on just staying in business.

This reduces stock trading and makes stock prices fall worsening the vicious cycle.

Bottom Line

If the Fed continues its current business plan, higher interest rates and draining the liquidity from the system, stock prices will likely continue to fall, even if they do so in fits and starts.

Because the manufacturing base of the Western world is nowhere near where it needs to be the supply side of the tangible economy won’t recover any time soon.

As a result, the algos will continue to sell stocks, deny loans, and direct companies to tighten their belts by cutting jobs. The net effect will be the reversion, or at least a meaningful reversal of the effects of globalization and just in time supply chain management.

The system is slowly adjusting. That’s why I see warehouses going up like crazy in my neck of the woods, the Dallas Fort Worth metroplex. And that’s why companies are relocating plants back to the U.S. But it will take time for the full or at least a meaningful reversal to occur.

At some point, however, the Fed will have to reverse its rate hikes and related activities. When it does, we will likely see a significant rally in the stock market. I expect that the rally in stocks will soon be followed by an economic recovery as the MELA system cranks back up and those algos change their protocols.

So, what’s the bottom line? Mr. Carville got it right. Up until 1990 or so, it was all about the economy. But in the present, and perhaps long into the future, it’s no longer the economy that’s in charge of the stock market.

Now, it’s the stock market that rules the roost.

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