The Dow and the Economy: A Misunderstood Relationship

Includes: DIA
by: Christopher Waller

Whilst the focus of investment commentators on the U.S. economy seems entirely logical, the relationship between the economy and the stock market is commonly misunderstood.

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The graph above was compiled with Federal Reserve Economic Data, and shows the nominal performance of the Dow Jones Industrial Average and U.S. Gross Domestic Product since 1900 and 1929 respectively. At first sight, it seems that the media hype on the economy is justified, as both the Dow and GDP seem to move in tandem. Indeed, between January 1933 and January 2011, the Dow generated a cumulative return of 7.0%, with U.S. GDP growing at 7.3%. Despite two world wars, economic, political and environmental crises, the Dow still began the 20th Century at 68.13 and finished at 11497.12 – seemingly a triumph for capitalism and market forces.

But look closer, and one will find that a simple ‘Buy and Hold’ strategy based on confidence in U.S. GDP growth would have led to long periods of frustration and poor performance.

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The chart above splits the 20th century history of the Dow Jones Industrial Average into seven sections. As we can see, there have been significant periods where the Dow and GDP have significantly diverged. The period between 1966 and 1982 offers the best example. In 16 years, the Dow fell 18%, and yet the production of the economy actually increased by around 450%! On the other hand, in the 18 years to 2000 the Dow rose by around 1300%, whilst GDP grew by 280%.

What does this mean for today’s investors? Perhaps surprising, it means that the Dow could continue to rise without the U.S. economy returning to full productivity. Whilst seemingly illogical, this may partially explain why we have returned to 2006 levels already, despite the numerous economic difficulties around the world.

Secondly, it is interesting to note the lengths of stock market underperformance. Whilst the crash from the Great Depression took 2 years, the other periods of malaise have lasted for around 16 years. The fact that we have now just gone over a decade with negligible stock market returns suggests that we could be nearing the end of a disappointing period. For long term savers, now would therefore seem to be a good time to buy and hold an index in the Dow. This can be done through the ETF DIA.

And so we have come full circle, for whilst we initially stated that a ‘Buy and Hold’ strategy based on economy history may be foolish, we can now conclude that one based on stock market history seems prudent.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.