![Money cycle graph for stock market drivers](https://static.wixstatic.com/media/625525_f33d4fe37be34b0d88a921585ee69450~mv2.png/v1/fill/w_980,h_656,al_c,q_90,usm_0.66_1.00_0.01,enc_auto/625525_f33d4fe37be34b0d88a921585ee69450~mv2.png)
Have you ever tried and failed to predict what the stock may do from day to day? A famous quote by Warren Buffett states that;
In the Short-Run, the Market Is a Voting Machine, But in the Long-Run, the Market Is a Weighing Machine.
When looking at the stock market in the short term it is impossible to predict what will happen however if we zoom out and look at the market over years and decades it can be observed that certain activities in the economy drive reactions in the long-term market movements.
Over the last few years, I have developed a framework to help understand this behavior better. Although there are many factors that can impact each of these on a short-term basis, ultimately over longer timeframes these are the primary drivers that determine the stock market behaviour.
If we understand the cause-effect relationship between the different drivers then we can predict what may happen to the stock market under certain economic conditions. In turn, it will give us an opportunity to profit, or at least minimize loss in certain economic environments.
Money and Supply Chain drivers
The amount of money available to customers and how many things they can spend it on has a direct impact on inflation. In summary, if there is more money chasing fewer goods to buy then the price of the goods goes up, this could be home prices, cars, or food at the grocery store. It's all the same outcome of an increase in prices also referred to as 'inflation'.
Below I have included some great articles that go into more detailed explanations.
Inflation drivers
Is the increase in prices that we see all around us, a recent example of inflation is the 9% inflation in the US that resulted after the Covid pandemic monetary stimulus where the government handed money to every citizen, without requiring any work (economic activity).
![A graph of US CPI and Inflation rate from 2014 to 2023](https://static.wixstatic.com/media/625525_db5315918f8142a9893468b9a2d4daf8~mv2.png/v1/fill/w_730,h_340,al_c,q_85,enc_auto/625525_db5315918f8142a9893468b9a2d4daf8~mv2.png)
Dangers of Inflation
If inflation is allowed to permeate the economy it can snowball into an unstoppable force that destroys savings, and businesses, and ultimately makes their currency worthless on the world stage meaning they can't afford to import products they need and cannot repay the debts they owe in other currencies.
Sometimes countries deviate from this principle to their own detriment, you can see the recent example in Turkey where the central bank was directed by the ruling government to keep lowering the interest rate (to encourage spending) despite soaring inflation of over 85%. The result was the catastrophic destruction of wealth for their citizens who had savings in the Turkish Lyra.
![A graph of Turkey inflation and interest rate from 2018 to 2023](https://static.wixstatic.com/media/625525_95cdcc04242b429782ea9d0872554108~mv2.png/v1/fill/w_730,h_340,al_c,q_85,enc_auto/625525_95cdcc04242b429782ea9d0872554108~mv2.png)
Federal Reserve (the FED)
Stable prices are so vital to a stable economy that most governments have a central bank that has only one job and that is to maintain price stability.
Interest rates
The primary way Federal Reserve banks maintain price stability is through the manipulation of interest rates. By changing the price it costs to borrow money it incentivizes people to spend less and save more. Since consumer spending is the primary driver of economic activity in most developed economies; diverting money away from spending eventually results in slower economic activity, as businesses sell fewer products and hire fewer staff.
Economic drivers
Includes all the activity in the country that results in goods or services that could be sold for profit, either domestically or internationally, this is typically measured in Gross Domestic Product (GDP).
I think of economic activity as the combined activity of all the businesses and organizations in the country that deliver goods or services to people.
Economies in capitalist countries are typically demand-driven, therefore the higher the demand for goods and services the more economic activity to create those services. Likewise, if the demand is directed away to savings through higher interest rates then the economy naturally slows as businesses deliver less and subsequently cut expenses such as laying off staff, not purchasing new equipment, or not taking on debt.
Stock Market drivers
If the economy is a measurement of the productivity of all companies in the country, then the stock market is the valuation of all those companies.
Valuations of business can be complex but it is fundamentally driven by one question,
How much money can I expect the business to generate for every dollar I invest?
Therefore it stands to reason, the higher the economic activity and the more profit companies are making the more valuable they become, and vice versa, if profits fall or expenses increase (such as interest on debt) and they become unprofitable then they will decline in value too, at the extreme they could lose all value and go bankrupt.
So although it may take some time to flow through each step eventually a change in money supply or interest rates will see an indirect impact on the stock market. We can therefore use the measures earlier in the cycle to anticipate to some degree what may happen to the stock market in the future.
In summary
When inflation veers outside of its ideal 'goldilocks' range of between 1-3 percent the FED is mandated to take either stimulatory or retrenchment measures. This is accomplished primarily by changing the overnight interest rate that is charged to banks for borrowing money.
![A graph of stock market drivers, Inflation, money supply, Federal Reserve, and the economy](https://static.wixstatic.com/media/625525_d1132aae128948cf9ddd8ac8b05a74e8~mv2.png/v1/fill/w_761,h_904,al_c,q_90,enc_auto/625525_d1132aae128948cf9ddd8ac8b05a74e8~mv2.png)
Which ultimately results in money flowing away from economic spending such as buying goods and services (or even other investments such as property or businesses), rather into savings. All this results in less profits for businesses meaning their stock prices decrease.
So observing what Money Supply and Inflation are doing in real-time, gives us insight into how our portfolio may behave in the medium and long term.
At Discover Done, we observe these behaviors to more accurately gauge the long-term direction of the stock market. Join our members list for free to get market updates that will help equip you better for long-term investing.
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