Don’t Judge the Economy By the Stock Market
I’ve complained before about the press’ habit of judging economic policy performance based on short-term stock market fluctuations. With the recent lows, this has been gaining more steam as a political talking point. Fortunately, it’s done so just as David Leonhardt put up a great non-political blog post that incidentally illustrates what a misleading line of thought this is:
For months now, we have been following the stock market’s decline here at Economix and arguing that the market was not as inexpensive as many others were arguing. Our case: Despite the enormous fall in stocks, the long-term p-e ratio — that is, the ratio based on the past 10 years of corporate earnings — was still roughly at its historical average.
But the declines over the last few weeks are starting to change the picture. I crunched some of the historical stock data kept by Robert Shiller, author of “Irrational Exuberance,” and it offers some reason for optimism. When the p-e has been between 12 and 13 over the last 125 years or so, stocks have doubled over the next decade, on average. (Adjusting for inflation, they have risen almost 50 percent.) Over all, there is pretty direct correlation between the p-e ratio and future long-term returns. For example, when the ratio has been 15 to 20, stocks have risen only about 50 percent over the next decade. When the ratio has been above 25, stocks haven’t risen much at all. [...]
In the other two great bear markets of the past century, in the 1930s and the 1980s, the p-e ratio ultimately dropped to about 6 or 7. To get to that level now, the S&P 500 would have to drop below 400, from the current 701, and the Dow Jones industrial average would need to be below 4,000. So stocks may well continue to fall. They may even still fall a fair amount.
Stock market advice aside, the political point is this. The stock market is, among other things, something that reflects the underlying state of the economy. Economic growth leads to earnings which leads to high stock prices. Recession leads to low earnings which leads to low stock prices. But there’s a substantial speculative oscillation around this long-term trend. And at any given point in time, the structural shift from a high-P/E dynamic to a low-P/E dynamic, or vice versa, can completely swamp the shifts in the underlying fundamentals. During the late 1990s, the economy was growing nicely. But the stock market was growing at a much higher rate for no particularly good reason. At the moment, the economy is doing poorly and so is the stock market. But while renewed growth might lead to a revival of stock prices, it’s also possible that we’ll undershoot the long-term average. That would be unfortunate for many people—though at the same time, probably good for someone like me who’s far from retirement and looking to add as much value as possible to my 401(k)—but I doubt it would be possible or desirable for public policy to impact it. In general, people prefer a rising market to a falling one. But there’s no particularly good reason to think that high P/E ratios serve the public interest in any systematic way.
38 Responses to “Don’t Judge the Economy By the Stock Market”
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March 3rd, 2009 at 2:32 pm
The stock market is, among other things, something that reflects the underlying state of the economy.
Recession leads to low earnings which leads to low stock prices
At the moment, the economy is doing poorly and so is the stock market
In general, people prefer a rising market to a falling one.
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Such profound economic pronouncements from a philosophy major. We’re awestruck.
MY you are in way over your head. Subtitle of this post: spin, spin, spin, spin
March 3rd, 2009 at 2:39 pm
Shorter Matt:
- Stock market falls under GOP President and GOP Congress = GOP’s fault
- Stock market falls under GOP President and Democratic Congress = GOP’s fault
- Stock market falls under Democratic President and Democratic Congress = fault of “structural shifts” rather like continental drift, far beyond the ability of mere humans to affect, so no blame can possibly be assigned
March 3rd, 2009 at 2:41 pm
What is your point? Yes it is true the stock market is not a perfect predictor of the true economic state but it is the best available. When it does over/under shoot actual economic performance this is merely a reflection of misguided expectations. And even if you were to ignore the stock market you would still be left with misguided expectations and an incorrect view of our true economic state.
No one is saying public policy should be aimed at improving the stock market but a stronger stock market will reflect more optimistic economic expectations (even if you have high p/e ratios). If you or Krugman or whomever think these expectations are wrong (and not in hindsight or whimsically) then go ahead make a profit and improve market efficiency.
March 3rd, 2009 at 2:45 pm
Has no one read their Taleb?
March 3rd, 2009 at 2:46 pm
What’s good for the economy as a whole is accurate valuations. If the Dow at 6,000 rather than 8,000 is a more accurate valuation, then it is better for the economy.
March 3rd, 2009 at 2:48 pm
The Dow is less like a thermometer and more like a dart board.
March 3rd, 2009 at 2:49 pm
Or alternatively, the Dow is like a thermometer: it can tell you what the temperature is now, but it can’t tell you what it will be tomorrow.
March 3rd, 2009 at 3:08 pm
I’ve never seen this addressed anywhere, but what’s the effect of automatic 401(k) deposits on the price of stocks? I stick a portion of my salary into the stock market every month like clockwork, whether the market’s up or down. So do millions of people.
How is that incoming flood of money not propping up prices? Or is it propping up prices and things are getting bad regardless?
Additionally: The Dow isn’t the best indicator of economic success we have. There’s also GDP, median income and unemployment. I think liberals tend to look more at them.
March 3rd, 2009 at 3:30 pm
Oh, now I get it – Matt was just parroting the Democratic Party TALKING POINT OF THE DAY:
President Obama told Americans to take a look at investing in the stock market this afternoon, a remarkable utterance for an American president, especially as the Dow Jones Industrial Average proceeds on its course Southward.
“What you’re now seeing is … profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal if you’ve got a long-term perspective on it,” the president said on a day that trading continued to hover under 7,000.
http://blogs.abcnews.com/politicalpunch/2009/03/bullish-obama-s.html
Say it all together now: Profit and Earning Ratios are at a good point
From Obama’s mouth to Matt’s ear. Of course Matt wouldn’t know a P/E ratio if it bit him in the butt
March 3rd, 2009 at 3:32 pm
Shorter Steve Sailer: It’s the fault of blacks and hispanics.
March 3rd, 2009 at 3:35 pm
Next up: Matthew explains why we shouldn’t grumble about carrying our money around in a wheelbarrow.
PS I liked the hilarious joke about saving long term in a 401K. So how is that working out?
March 3rd, 2009 at 3:38 pm
PS When people lose their life savings because of government fuckups, they tend to get kinda testy. You know — Look for someone to blame. Historically, they haven’t been all that concerned about being fair about it, either.
Google “Holocaust”.
March 3rd, 2009 at 3:41 pm
Why Matt, by your reasoning the ObaNation should be hoping that the market is doing even worse all through next year. You know, those expanded buying and growth possibilities!
But you aren’t Blanche you aren’t!
The markets are telling us that they have no faith in ObaStimulator.
The markets are telling us that like the CBO they believe that the ObaStimulator will be bad for the economy for the next ten years and counting.
And the real reason Matt doesn’t like the markets as informative?
Because unlike the ObasMessiah the markets actually produce metrics, an objective method of measuring performance.
So quack away little ObaDucks… the moment the markets show anything like consistent growth then you will be quacking to the sky how it is all because of ObaStimulator!
Or is that turkeys drowning in the rain?
March 3rd, 2009 at 3:57 pm
Glad to see Matt getting ripped for this stupid post. This is not something that would have ever been written when Bush was president. The fact is, the markets are correctly re-assessing future growth opportunities under an Obama administration that has no clue whatsoever to address the banking crisis, and that will vacuum more wealth out of the economy in the form of higher taxes on dastardly rich people, and a carbon tax that makes everything more expensive, to name but two examples.
March 3rd, 2009 at 4:11 pm
“Glad to see Matt getting ripped for this stupid post.”
Give me a break. It’s the same neocons that parrot Republican talking points, they just all happened to congregate in one thread.
The “market’s going down because Obama’s allowing marginal tax rates on income over $250k to sunset back to 39% in two years, just like he’s been promising forever” has to be THE DUMBEST Republican talking point I have literally ever heard.
Oh, and Brad, nobody has any clue whatsoever how to address the banking crisis. There is no magic fix here, not even from the world’s smartest economic minds. So yeah, if the market’s just now facing that reality and adjusting to where it should have been all along, sucks for anyone who thought it would stay over 10k just because Obama won. But that’s what happens when you create unregulated credit default swaps and a multi-trillion dollar shadow banking system, eh?
March 3rd, 2009 at 4:30 pm
On that point, from today’s poll:
Who will do a better job getting the U.S. out of the recession?
Democratic Party: 48%
Republican Party: 20%
Both Equally: 8%
Neither: 16%
Why, it’s almost as though you’re all full of shit!
March 3rd, 2009 at 4:58 pm
Adam Says:
March 3rd, 2009 at 4:30 pm
On that point, from today’s poll:
Who will do a better job getting the U.S. out of the recession?
Democratic Party: 48%
Republican Party: 20%
Both Equally: 8%
Neither: 16%
Why, it’s almost as though you’re all full of shit!
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opinion poll = people expressing opinions using free hot air
stock market = people expressing opinions using hard-earned money
Which would you take more seriously?
March 3rd, 2009 at 4:58 pm
Hmm.. I’m sorry. Which Matt are we talking about? The one who says that the stock market is a relatively weak descriptor of the economy as a whole, or the one who says that the dropping stock market demonstrates that productivity gains are a myth..
Hmmm.
There is no doubt that some of the current drop is the ongoing echoes of the previous Congress and President (feckless Fannie Mae and freakishly free-flowing fundage from the Fed). Clear-headed analysis demonstrates that a significant chunk of the current drop is the fault of the business-hostile policies of the Obama administration and the utter crepulence of the stimulus bill.
March 3rd, 2009 at 5:00 pm
Re Adam at 16: “Oh, and Brad, nobody has any clue whatsoever how to address the banking crisis. There is no magic fix here, not even from the world’s smartest economic minds.”
—————–
I pretty sure that buttfucking the taxpayers to the tune of $10 Trillion is not part of the solution.
I’m not sure if I have the FULL solution but I’m pretty sure that REAL firing squads on Wall Street is part of the fix.
March 3rd, 2009 at 5:14 pm
Equity indexes are declining because forward looking profit forecasts are either declining, have become negative, or in many cases are completely unknowable.
That the Democrats often demagouge against ‘profits’ have little to do with it; we have not quite hit the bottom of the business cycle (but imo are close). Once GDP shows more signs of a cyclical bottom, the stock markets will recover.
I’ve never seen this addressed anywhere, but what’s the effect of automatic 401(k) deposits on the price of stocks? I stick a portion of my salary into the stock market every month like clockwork, whether the market’s up or down. So do millions of people.
It’s also my opinion that a good deal of the 90’s overshoot was not only caused by tech bubble irrational exurberence (i.e. reflected in QQQ), but also by a bunch of first time baby boomer buyers (i.e. reflected in DJI). However, this S-curve affect has mostly run it’s course, as the X’er and subsequent generation are somewhat smaller and has been more broadly invested in stocks from the beginning. It will however become interesting round bout 2015 or so when the boomers start the big wave of sell-offs to pay for retirement. (PJ O’Rourke said something like this in one of his books)
March 3rd, 2009 at 5:22 pm
duBois Says:
March 3rd, 2009 at 4:40 pm
PS I liked the hilarious joke about saving long term in a 401K. So how is that working out?
March 3 – Jan 20 = 6 weeks.
Not Long Term.
=============================================================
DJIA
10/27/08 9325
3/3/09 6726
- 28%
But long term is relative. If you are a geologist you have to get out 10,000 years or so before you’re talking long term.
Then again, now that Keynesianism has taken over the Obama administration it’s good to remember that immortal JMK quote: “In the long run, we’re all dead.”
March 3rd, 2009 at 5:39 pm
Apologies if I missed it, but does Matt mention interest rates at all?
Somewhat of a relation between PE and interest rates. PE of 12 and interest rate of 1% isn’t the same deal as PE of 12 and interest rate of 12%.
March 3rd, 2009 at 5:59 pm
I hate to agree with the rightwing crowd, but I also think this post is bs. I think in five years it won’t be, however. McCain or Obama, the financial services sector was, is, and will be shrinking. Which is a good reason to pile on the Obama administration’s TARP policies. The paradox, for the right, is that piling on simply underscores a fundamental incoherence: all rightwing policies over the past thirty years have been premised on the idea that the middle class, while it might suffer from lower rates of earnings increase, or even, as per the 2001-2006 period, none, would benefit anyway, because they’d be tied in to the speculative economy. The idea that we should liquidate, liquidate liquidate simply deestroys this idea, lock, stock and barrel. The Dittoheads getting up in arms cause the Dems are going to tax 401(k)s will have a hard time gaining tractin if nobody has 401(k)s. And guess what? There are other ideas for more secure accounts out there, paying less interest, and being much more progressive. The financial services sector has been the absolute motor of income inequality, of which the right is so proud, and watching it spiral downward, you are watching rightwing power disappear. Of course, on the far right, that will just lead to teabaggin’ fascism.
As the financial sector weakens, its hold on the political process, which has been exercized in a major way to prevent tax increases on the wealthy, weaken.
All of which is wonderful news! Burn baby burn – let the teabaggers get their wish. Pull out the life supports for this horrendous and parasitic piece of the economy. At the moment, that more money is being spent this month to keep AIG afloat than was spent in the last fifty years to, say, find a cure for malaria shows the kind of egregious misallocation of capital that comes from the great alliance of big biz and government. It will take years to repair the misallocationof capital to high yield fictions which were the entire substance of the Bush boom.
Oh, and in other news – that Dixiecrat talking point about Toyota, at least, with its wonderful Southern factories, not needing a damn government handout will have to be folded in today. They are asking for the first billion from the Japanese government. Gee, who woulda thought…
March 3rd, 2009 at 6:03 pm
But long term is relative.
Innuendo is a terrible thing to waste.
March 3rd, 2009 at 6:24 pm
“In the other two great bear markets of the past century, in the 1930s and the 1980s”
I think Leonhardt meant to write “1970s” instead of “1980s” there. The last secular bull market in stocks went from 1982-2000, and was preceded by a secular bear market in stocks from about 1966 to 1982.
March 3rd, 2009 at 6:26 pm
My understanding is that committing sabotage during a time of war is a capital offense. Look at what Franklin Roosevelt did to those Nazi agents who landed on our coast in WWII, merely for intent. Some of those agents had a claim to US citizenship.
Yet what do you call this financial disaster, if not devastating sabotage? Committed and supported by our loud right wing — and all the time while they waved the flag and wore their faux patriotism on their sleeve.
March 3rd, 2009 at 7:56 pm
The chickens have come home to roost from Wall Street selling junk and ripping off investors. They have themselves to blame for the lack of faith in their rotten market.
March 3rd, 2009 at 8:38 pm
I believe this President will cost all the hard working people who actually plan on retirement funds to lose a large majority of their savings. Why does it not surprise me when Bernacki says one thing and Obama says another on the very same day.
Which is it Obama, should we buy stocks? Which is Bernacki, should we forget about buying stocks?
Jeez, does anyone know what they are doing out there in DC?
March 3rd, 2009 at 10:38 pm
You might notice that “hard work” and “retirement fund” have nothing to do with each other. Now, they used to, but as the pension plans changed so that instead of being a straight company payout, it was a wonder”ful opportunity to “invest”, they became totally separate things. It is like thinking, I’m hardworking, so I deserve to win at the Las Vegas slot machines.
Sorry buddy. No.
March 3rd, 2009 at 10:53 pm
Leonhardt is, of course, wrong on the facts. The market bottomed during the great depression when the p/e ratio was NMF (in other words, E was negative.) It started its ascent in ‘82 around 15. The reason is very simple. Stocks bottom during bad times, and in bad times current earnings are below average, so the denominator is very small causing the p/e ratio to rise. In other words, Leonhardt is either obfuscating, or dense. His argument makes no sense at all. The question is not what current years earnings are, but some good measure of earning power. I wish reporters weren’t so incapable.
March 4th, 2009 at 12:15 am
Apparently two straight humiliating election defeats haven’t taught the rightwing (at least as it’s posting on this blog) any respect for honest argument.
Just because Rush tells you Obama is responsible for the economic mess we’re in doens’t mean it’s true. It’s amazing you idiots can manage to figure out how to type your drivel into your computers.
March 4th, 2009 at 3:48 am
This is just adorable.
A year and ago, the stock market thought AIG was a company worth $60 a share (now it’s worth 0.43 per share and is owned 80% by the government) and Bear Stearns was worth $30 a share (it collapsed). Would you say the market was good at predicting the short term future of those companies?
And if the investors who owned those companies’ stocks couldn’t predict the future of those companies, what makes you think they can predict the future of the entire, complex U.S. economy?
So many companies that only a year ago the Stock market thought were doing okay have gone bankrupt (not just posting a few quarterly losses – they’ve gone completely bankrupt) that it’s really laughable that anyone thinks the stock market is any good at predicting the future.
And as brewmn pointed out, it takes a special kind of person to call a recession that began in December 2007 according to the NBER the “Obama recession” since in December 2007 Obama was way behind Hillary Clinton in the polls (meaning few thought he’d be President). And by special kind of person, I mean an “idiot.”
March 4th, 2009 at 4:24 am
Just more excuses for Democratic incompetence. Obama is destroying this country — the RICH are the only ones who can make this economy work again!! (I mean, come on. It’s not like poor people were doing much for the economy anyway.)
http://relevantelephant.wordpress.com
March 4th, 2009 at 8:02 am
The stock market is a gauge of investors’ collective opinion about short term profit potential. The daily spikes and falls are noise in reaction to daily news. The long term trend is the only thing that reflects anything real about the underlying economy, and if it were easy to discern the long term trend amid the daily noise, we’d all be a lot richer than we are now.
It only makes sense that the stock market would react negatively to a policy of investment in the infrastructure necessary to pave the way for a long-term economic shift. There’s very little short-term profit potential in that. A lot of long term investors (Buffet et al) are buying stocks now because of optimism about the long-term prospects (Buffet mentions 5-20 years).
That long smooth ascent from the dot-com bottom until 2007 was in part an artifact of so much cheap money flooding the system. It was a fiction, and when that cheap money dried up, we all realized that just how distorted things had become. As is now perfectly clear, that ascent did not reflect the real health of the underlying economy. It reflected irrational speculation and a very short memory. Institutional and amateur investors alike got quite used to making 1% or 2% a day with some occasional “buy the dips” moments. That’s not real. That was the historical abberation.
March 4th, 2009 at 12:22 pm
Interesting Bloomberg article about pension fund investments and shortfalls: http://www.bloomberg.com/apps/news?pid=20601109&sid=alwTE0Z5.1EA
Apparently, pension funds have been getting their cues from Madoff and Stanford on reporting returns. But not to worry! What is 1.5 trillion among friends?
Ah, the era of chasing the highest yield and pretending that it was the efficient allocation of capital that was going on! I love the smell of capitalist stupidity in the morning.