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April 11, 1997 AS THE Dow Jones Industrial Average zoomed past 7,000 in early March, it seemed only a matter of time until the roller coaster came back down. But the belief that stocks will inevitably fall to earth may reveal more about our difficulties in understanding growth and inflation, rather than having anything to do with the market. Consider these facts: From 1960 to the present, the gross domestic product of the U.S. economy has risen from $526 billion to about $7.7 trillion; which is a fourteenfold increase. Over that time, the Dow Jones Industrial Average rose from 618 in 1960 to just over 7,000 in early March, only an elevenfold increase. Other indexes show stocks rising at about the same speed. The New York Stock Exchange index rose from 30 in 1960 to a peak of 420 in early March, a fourteenfold increase. The Standard & Poor's composite index went from 56 in 1960 to a peak of 810 before the declines of the last few weeks, again a fourteenfold increase. In short, over the last few decades, the stock market has risen at about the same rate as the overall economy! Thus, to think about whether the Dow is unsustainably high at 7,000, it's useful to think about whether the gross domestic product has grown unreasonably high at $7.7 trillion. Inflation, which has raised prices by a factor of five since 1960, is one reason the economy looks bigger. But although I am mildly shellshocked by today's $7 movie ticket, I don't expect price levels to crash back to their 1960 levels. The U.S. population has risen from 180 million in 1960 to almost 270 million today, a rise of 50 percent, which has expanded the economy in its wake. Although I do feel that some of my favorite outdoor haunts are becoming more crowded, I don't expect population levels to decline. Finally, the real economy has also tripled since 1960 because of real gains in productivity and technology. Although I am frequently astonished at what is now possible in medicine, computing, home entertainment and many less visible areas of the economy, I don't expect a technological reversal. But if inflation, population growth, and new technology are reasonable causes of a larger economy, they are equally valid causes why the stock market based on that economy will be higher as well. Of course, the stock market will not move in lockstep with the economy. Various factors like taxes and interest rates, expectations about profits, changes in patterns of corporate finance, and the presence of inflation or recession will matter greatly. The stock market moves in fits and starts. For example, the Dow Jones Industrial Average rose by 50 percent from 1960 to 1972, then dropped 7 percent from 1972 to 1982, before taking off on its 15-year expansion to the present. Thus, another way of thinking about the run-up in stock prices these last few years is that, sooner or later, the market had to catch up for its relatively dismal performance during the 1970s. This volatility in prices doesn't mean that stocks are a poor investment. Remember that higher stock prices are only one way of making money in stocks; many companies also pay dividends, which add to investors' returns. But it does mean that investing in stocks requires taking a medium- to long-term horizon -- say 10 years or more -- and having a strong stomach for riding out the waves. When you have your retirement money entirely invested in stocks, as I do, it's a little sickening to watch the market fall. Even if I were foolish enough to predict where the stock market will head in the next few weeks, I hope and trust that you would not be foolish enough to invest any money based on my prediction. The stock market offers no short-term, money-back guarantees. But for the typical small investor, who is in no position to joust in the stock market with the savvy professionals at gargantuan pension and mutual funds, suffering through the downs of the stock market is the easiest way to be in a position to take full advantage of the ups. << Back to 1997 menu |
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© 2010 Timothy Taylor |