Last week’s swoon in the stock market was the worst in four years. The Dow Jones industrial average fell by 4.2 percent, punctuated by a drop of 200 points on Friday. Overshadowed by the losses, however, was brighter news about the economy, which grew by a healthy 3.4 percent annually in the last quarter, according to the Commerce Department.
If the figures seem contradictory, that’s because, historically speaking, they are. The fate of equities and the fortunes of the economy are correlated in the long run, according to a new study by Charles Mulford and Narayanan Jayaraman, of the Georgia Tech Financial Analysis Lab.
Comparing nominal gross domestic product—the total value of all goods and services produced in the United States—to the Dow averages since 1916 shows that the two numbers are linked. For instance, in 1932, when the index averaged 64.6, the GDP in the U.S. was nearby at $58.5 billion. In 1966, the Dow averaged 873.6 while the national GDP was $787.8 billion, and in 2007, as the Dow has hovered between 13,000 and 14,000 the latest GDP figures (not adjusted for inflation) reported by the Bureau of Economic Analysis came in at $13,756 billion.
Surprising? Not really. “There is a certain intuitive appeal to the observation that the value of the companies comprising a significant component of our overall economy should be expected to grow at a rate commensurate with the economy’s growth,” write Mulford and Jayaraman.
But as last week’s figures–a mere blip in the long-term economic picture–show, the economy and the Dow do tend to diverge at times. In 1929 the Dow industrial average exceeded GDP by 200 percent, the study said, while in 1982 it was 73 percent below GDP, and in 1994 was 46 percent below GDP. The reason for the gap is that certain economic news tends to rattle the markets without necessarily dragging down the overall economy. In the 1960s “the disparity between the two grew as oil shocks, inflation, and high interest rates took their toll on share prices,” according to the report.
But as revenues of companies on the Dow increase to make up a larger part of GDP, the index’s performance tends to converge with that of the economy as a whold. During the last 50 years, the companies on the Dow have comprised an average 14 percent of GDP. The number more recently has reached 18.9 percent, as the gap between stock performance and GDP have narrowed.
Although the relationship between GDP and the Dow may seem simplistic, the authors write, share prices measure a company’s economic output (as a multiplier of revenues) in the same way that GDP measures a country’s output. If history is any guide, Mulford and Jayaraman say, nominal GDP growth (ignoring inflation) falling between 5 percent and 6 percent would bring returns on blue-chip stocks of 7 percent to 9 percent.
“The implication is that as long as we are able to maintain economic growth with low inflation and interest rates, a significant run up or decline in share prices would not appear to be likely,” Mulford and Jayaraman said.