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Financial Crisis vs. Economic Crisis

The news over the last several weeks has been overwhelmed with headlines about our current financial crisis. Many people have panicked and pulled their money out of the stock market, opting to hold cash instead.

Those people seem to be misunderstanding two things:

  1. We’re having a financial crisis, not an economic crisis.
  2. When you buy a stock, you’re buying a company’s future earnings.

This is a Financial Crisis

It’s only the financial markets that are in complete turmoil. Our economy (while not exactly flourishing) isn’t having any sort of meltdown. According to the US Bureau of Economic Analysis, our inflation-adjusted GDP has still shown positive growth so far this year. Our unemployment rate is just a hair over 6%. Our average unemployment rate from 1948-2007 is 5.58%, according to the Bureau of Labor Statistics. This is hardly the worst we’ve ever seen.

So why would this affect your investing strategy?

Because You’re Buying Earnings, Not Price Fluctuations

As Warren Buffett (probably the greatest Oblivious Investor) so often reminds us, when you buy a stock, you’re buying a company’s future earnings. The long-term profitability of an investment is determined by the long-term profitability of the company, not by the short-term fluctuations in the company’s share price.

So if you’re invested in index funds (or other broadly diversified mutual funds), you’re banking on the long-term earnings of our economy overall. Or, to put it differently, you’re making a bet that over the long run, our country’s companies will continue to be profitable. And so far (with the exception of what’s happened to a handful of companies in our financial sector), I’ve seen no evidence to indicate that our economy’s overall profitability is likely to be any worse than it’s been in prior decades.

The big takeaway: All this news is just noise. It will pass. The businesses of our country (and other countries) will continue to earn profits. I’d like to have my share of those profits. What about you?

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Comments

  1. I really did love this post, and am so glad I stumbled across your site through Tip’d. Please keep up the good work.

  2. I would be interesting to see a follow-up on this post now that the real economy is in crisis

  3. misanthropope says

    i think that you missed an important point. yes, the crisis originated in the financial markets and not the “real” economy, but generally the term “financial markets” is used to refer to the STOCK market.

    this crisis originated in the _credit_ market, which is considerably larger and much more significant to the real economy than the stock market.

  4. Hi Argy.

    If you read some of my recent posts, you’ll see that I’d take issue with the assessment that our economy is in crisis.

    Yes, we’re in a recession. And yes, things are worse than they’ve been in years. But crisis, as in “our economy will entirely collapse if we don’t do ____”? It doesn’t look that bad to me. (Granted, I could be entirely wrong.)

  5. It is hard to precisely measure the effect of the financial crises on the economy.It is however evident that when financial markets are adversely affected,this in turn will affect the economy(not necessarilly cause a crisis).Companies are not spared.For example,a co. may forgo a viable investment opportunity due to difficulties in accessing capital.The stock market has greatly shade off in value,this means companies may not consider floating their shares in the stock market.Secondary issues,rights issues etc may not work well in a bearish market.Companies are left with few options like corporate bonds(rates may also be high especially for co’s with poor credit rating)and syndicated loans.People therefore have something to worry about, but all is not gone.This is just a case of history repeating itself.

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