The Dow at 1600 seems a little too scary. Can we really get that bad and fall 3/4 from this point? Hopefully we won’t. But economic theories don’t preclude that possibility. This is because of the fundamental relationship between the stock market and the economy.
Businesses produce profits and the profits impact both the GDP and stock values. You can have the profits go closer to zero and the GDP still at non-zero due to the other components in the GDP, but you cannot have the GDP going to a toilet while profits keep going up indefinitely. Thus, GDP forms an upper bound for corporate profits. Generally, the market capitalization of the entire economy is a product of GDP, corporate profits as a percentage of GDP and what investors think the future will be (Price to Earnings ratio).
Stock market values depends on three main factors in the short run -
- Market psychology (affects Price to Earnings)
- Growth in corporate profits (affects Earnings)
- Interest rates (affects Price to Earnings)
However, as Buffet once said, “In the short run, the market is a voting machine; in the long run, it is a weighing machine”. In the long run, market psychology and interest rate growth don’t have much impact on stock valuation and corporate profits cannot grow forever – limited by GDP level. So, in the long run stock values would be linear in Gross Domestic Product (GDP) – that indicator of what the economy actually produces.
Figure 1 has the US GDP for the last 60 years in 2000 dollars. GDP has grown about 7 times since 1947. So you expect the stock market value to be somewhere in that region, right? The relationship held 'till about the early 1980s and then it went out of whack (Figure 2). It grew nearly 30 times since 1950. From 1950 to 1982, the Dow grew about 3.5 times while GDP grew about 3 times; they roughly tracked each other. However, since 1982, the Dow has grown 8 times (assuming a value near 6500), while the US GDP has grown only about twice. So, if the historic GDP relationship matters, Dow must come to a level of 1600 (twice what it was 27 years ago).
Some of the factors that partly helped this included an increase in foreign income (that gets to stock value but not to GDP), but for most part we formed a massive bubble built in the back of market psychology and historically low interest rates, while the corporate profits a a percentage of GDP increased due to the relaxation of rules. These cannot continue forever. We might be in for a painful readjustment towards long term averages and that could make the Dow at 2000 a reality.
US GDP for the last 60 years in 2000 dollars
Data Source : St. Louis Fed
Dow Jones Industrial Average (Blue) and S&P 500 index since 1950.
Source: Yahoo Finance