What is the stock market?

Markets are where goods and services are traded. In ancient times, goods and services were traded through bartering. Imagine if when you went to the grocery store to buy milk and bread you had to bring in a cow. This is explains why cash was invented. Now we would sell the cow, take the cash from the sale, go to the grocery store, and buy our bread and milk.

The stock market is not much different from the markets where we buy groceries. The only difference is that instead of selling groceries, they sell stock. Stock represents part ownership in a corporation. In theory, if a company is profitable its stock price should increase in proportion to the earnings but this is not always the case.

In the 1990’s everyone was investing in the latest dotcom stock. Even though most of these companies failed to show a profit, their stock prices continued to increase because of the law of supply and demand. Since the demand for these stocks was unusually high, the prices went up. However, when investors realized that these companies were not profitable, they began selling off their stock and prices went down. These unprofitable dotcom businesses went out of business leaving only those that were profitable. This caused the market to stabilize causing stock prices to bottom out and begin increasing again.

We are seeing a similar situation today. Banks were issuing sub-prime mortgages and showing high profits. These high profits led a high demand for the stocks of the banks and financial institutions issuing these loans. However, when borrowers began to default on the loans, investors became skittish and began selling off their shares, leading to the current market decline. If the banks and financial institutions who issued these toxic loans were allowed to fail, only the profitable companies would remain. This would bring stabilization to the markets, allowing the markets to bottom out and begin to grow once again.

President Obama recently mentioned that he paid little attention to the stock market, claiming it was nothing more than a tracking poll. As we learned in last weeks posting, many individuals today have their 401K’s and pensions invested in the stock market. These hard working individuals are witnessing the disappearance of their retirement nest egg and the money they were saving for their children’s education. I urge President Obama to make restoring the stock market a priority since it represents the wealth of hard working Americans.

We must allow the current market correction to happen. Bailing out unprofitable companies does nothing but prolong the correction. After the correction has run its course and the unprofitable companies have gone away we need to offer incentives to those companies that are left so they can become profitable. This is what tax cuts accomplish. They worked when JFK did them in the 1960”s. They worked when President Reagan did them in the 1980’s. They even helped lessen the impact of the terrorist attacks of 9/11. There is no reason to doubt they would help us get out of this current recession.

The main tax that should be cut is the capital gains tax. This will encourage investors to put their money back into the stock market where their taxes will be lower. We should also cut the corporate income tax rate. This will result in a two-fold benefit. First, it will encourage companies to remain in the United States instead of going to other countries where their taxes would be lower. It would also increase the after tax earnings of these companies, attracting new investors and creating new jobs. The question I have is why this is so difficult for President Obama and his so-called highly educated economic team to figure out. If you have an answer to that question, feel free to leave your comment.