A report for Barclays Capital on recoveries in share prices after severe falls, such as in 1982 or 2009, is important for stock market investors. But it also throws a light on economic theory.
As John Authers notes in the Financial Times: 'Looking for the key factors driving such recoveries, Barclays found that economic growth and profits were not particularly important. Instead, the strongest link was with credit spreads. Provided credit continued to get cheaper (as shown by the extra spread for corporate debt compared to government debt), then relief rallies could continue. Once credit spreads widen, equities cannot make much headway.' Authers' video on this, which contains further statistical illustration, is well worth watching.
What is expressed in this data is not only changes in evaluation of risk but a rather good practical illustration of changes in liquidity preference. Keynes in The General Theory of Employment Interest and Money clearly explained that for investment to take place it is not sufficient for the rate of profit to exceed by a minimal fraction the rate of interest. There is an advantage in holding flexible assets, cash or near equivalents, compared to non-flexible ones. For investment to be take place it is therefore necessary that the rate of profit equal at least the rate of interest plus whatever rate of return is necessary to induce the investor to forego the advantage of liquidity. The rate of return sufficient to create an inducement to forego liquidity, that is to offset liquidity preference, changes according to circumstances. Hyman Minsky, of course, analysed some consequences of this when, as in a modern economy, investment is carried out on the basis of credit. Risk is a factor influencing the rate of return that must be offered to overcome liquidity preference.
While Keynes was analysing the development of effective demand in the productive economy, and shares are far more liquid than productive assets, nevertheless the same process is clearly working. The Barclays Capital data is therefore of interest not only practically from the point of view of stockmarket investing but from the viewpoint of illustrating and validating economic theory.
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