The London Economist gives a pessimistic review of the past summer's movements in the stock market. If you can get your undergraduates to read it, they'll be exposed to a bunch of important points--that stock market values depend on expected future profits; that future profits depend on productivity growth, how close the economy is to full employment, and on the strength of competition; and that high stock market values are a good cause/signal of high levels of business investment.

I always like to grab an article like this from the Economist and hide it away until we begin talking about "animal spirits" and the determinants of investment in the Keynesian model.

Economist.com: The Stock Market: Jumping Yet Jumpy: ...From the beginning of May, when the Dow Jones Industrial Average stood above 10,000, it slid to a low in July of 7,702. The broader S&P 500 index and London;s FTSE 100 followed similar routes south.

Having been stamped on heavily after earlier slips, the Nasdaq Composite index (with a heavy weighting of technology companies) had little strength to resist and so sank too. With at least one eye on Wall Street, many other markets followed suit. Then, almost as abruptly in August, after many investors had abandoned their desks for the beach, the markets regained their nerve and headed higher again. Sunny days are here again? Not necessarily.

There are still too many unanswered questions to justify untempered optimism. For starters, as David Hale, chief economist of Zurich Financial, notes, the outlook for corporate profits is still mixed. America's Federal Reserve does not want to be seen reducing interest rates to prop up the stockmarket. There is little prospect that the Bush administration and Congress will agree on another fiscal stimulus to help the US economy; and investors can only guess at how the impending changes in corporate governance and accounting policy now being shepherded through Congress will affect companies' profits or, indeed, the economy. Then, of course, there is a risk of war with Iraq, which could loom larger as the autumn draws near...

If ever there was a year in which, as the saying goes, “to sell in May and go away”, this was surely it. Spooked by tales of wrongdoing and corporate excess, the equity markets did what comes naturally when confidence drains away: they dived. From the beginning of May, when the Dow Jones Industrial Average stood above 10,000, it slid to a low in July of 7,702. The broader S&P 500 index and London’s FTSE 100 followed similar routes south.

Having been stamped on heavily after earlier slips, the Nasdaq Composite index (with a heavy weighting of technology companies) had little strength to resist and so sank too. With at least one eye on Wall Street, many other markets followed suit. Then, almost as abruptly in August, after many investors had abandoned their desks for the beach, the markets regained their nerve and headed higher again. Sunny days are here again? Not necessarily.

There are still too many unanswered questions to justify untempered optimism. For starters, as David Hale, chief economist of Zurich Financial, notes, the outlook for corporate profits is still mixed. America’s Federal Reserve does not want to be seen reducing interest rates to prop up the stockmarket. There is little prospect that the Bush administration and Congress will agree on another fiscal stimulus to help the US economy; and investors can only guess at how the impending changes in corporate governance and accounting policy now being shepherded through Congress will affect companies’ profits or, indeed, the economy. Then, of course, there is a risk of war with Iraq, which could loom larger as the autumn draws near.

As Alan Greenspan, chairman of the Fed, noted in his most recent testimony to Congress, “the productivity of the US economy has continued to rise at a remarkably strong pace.” The trouble is, since 1999 those gains in productivity have failed to feed through into companies’ profits. So, although profits have now begun to rise again, “managers seem to remain sceptical of the evidence of an emerging upturn.”

This would matter less if companies were not operating in such a competitive environment; or if their profit margins were wider and growing more quickly. Investors worry, too, that recent efforts by regulators, in the wake of the scandals at WorldCom and others, to define corporate profits more conservatively—Standard & Poor’s, a rating agency, for one is to concentrate on “core earnings” only—will contribute to the squeeze on reported profits.

There are other concerns too. Two consecutive years of declining stockmarkets have already increased the pressure on companies’ own pension funds. On both sides of the Atlantic, firms face the prospect of having to top up these funds if share prices fall for the third year in a row. Indeed some, like Rolls-Royce, already have to. Many companies have lowered to 6-7% the return they expect to generate from the investments in their pension funds. This may still be too high. Indeed, the American government has calculated that companies will face a combined shortfall of $110 billion if the return falls to 5%.

Worse, the decline in the stockmarket may further undermine the confidence of consumers which, in turn, will contribute to the squeeze on profits, and so on. The most recent data on the American economy show that GDP contracted for three consecutive quarters last year, not just one period as at first thought. Although the overall decline was only 0.6%, the smallest of any recent recession, it was unusual nonetheless because it was caused by a slowdown in fixed investment, not by a slump in house-building or consumption. Indeed, as in Britain, the rise in house prices has contributed significantly to the strength of consumer spending, particularly on furnishings and the like. The fall in share prices has already reduced the level of household wealth in America from a peak of 4.2 times personal incomes two years ago to 3.4 times now. If the cost of mortgages were to rise because of an increase in interest rates, household incomes would be put under even more strain.

For years, the strength of the dollar and the buoyancy of asset prices in America helped to attract inflows of foreign capital. Much of this went into the stockmarket. Now there is a danger of the reverse happening. A softer dollar has already contributed to a reduction of capital flowing from Europe to America. During the first four months of this year, the flow fell to $7.5 billion from $40 billion during the same months of the previous year. There are also fears that private investors are starting to withdraw money held with banks or investment houses in America because of new controls on foreign depositors imposed in the wake of last year’s terrorist attacks in America.

But money withdrawn from American markets is unlikely to fuel booms in other parts of the world. While America’s economy remains so dominant and its stockmarket recently so depressed, few investors can contemplate chasing up equity prices elsewhere. That is one reason why most big markets have tended to move in step this year, and why investors hang on Mr Greenspan’s every word. It will therefore be a comfort that Mr Greenspan now forecasts that America’s GDP will grow by 3.5% to 3.75% this year, rather more than he thought at the beginning of the year. However, investors will draw little cheer from the fact that it would not take much of a shock, in its present weakened state, to knock the stockmarket off course again.