"The Economy and the Market - Is There a Connection?"

Sydney M. Williams

Thought of the Day

“The Economy and the Market – Is There a Connection?”

July 28, 2010

In late 2001, Carol Loomis conducted an interview with Warren Buffett that gained some notoriety – it was based on a speech Mr. Buffett had given Allen & Co.’s annual Sun Valley corporate gathering. In it he compared moves in the DJIA to growth in GNP through two seventeen-year periods – 1964-1981 and 1981-1998. Mr. Buffett determined that in the first period, a dismal period for stocks, the economy did very well, with GNP gaining 373%. During the second period, with stocks gaining 949%, GNP was up only 177%.

Mr. Buffett attributes the difference to two economic variables and to one psychological factor. In the first period, interest rates moved higher, while in the second they moved lower. Also, in the second period, corporate earnings moved dramatically higher as costs were taken out of operations. In the first period they did not. The psychological factor was, as Warren Buffett says, “People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them.” The latter statement also explains why most investors are late to see both deteriorating and improving market conditions.

The relationship has been the subject of academic studies. Dimson, Marsh and Staunton’s Triumph of the Optimists: 101 Years of Global Investment Returns, concluded that there is no correlation, or perhaps a negative correlation, between stocks and GDP. Menzie Chinn, writing in Econbrowser, in late 2007, argued there is little relationship between the two, and included a statement of the obvious, “stock prices are an imperfect indicator of recessions and booms.” James Brumley, editor of “Small Cap Network” newsletter, recently wrote, “Generally speaking, the GDP figure was a pretty lousy tool, if you were using it to forecast stock market growth.”

Nevertheless, over long periods of time there seems to be a relationship. During the fifty years from 1950 to 2000, GDP grew from $293.7 billion to $9.951 trillion, an increase of 32.9 times. During the same period, the DJIA rose from 235.41 to 10786.85 or 44.8 times. (If one were to extend the time frame to 2010, the gain for both indices would be the same, as stocks retreated and GDP continued to grow.)

However, investing is never easy and lessons once learned may no longer apply. Over the past decade stocks and per capita GDP, adjusted for inflation, moved in unison. Stocks declined 15.5%, while per capita GDP, in constant dollars, declined 0.3% – assuming $9.8 trillion GDP in 2000 and $13.3 trillion in 2009, a population increase of 29 million to 310 million and using an inflation calculator. During the 1990s, in contrast, both GDP per capita and stocks moved higher.

It seems to me that the economy and the stock market, while not connected at birth, are certainly related. The stock market may be child to the economy and certainly benefits and/or suffers depending upon its direction. And stocks, also, do influence their older, less volatile relative. Over the past twenty years (two very different ten-year time periods), the S&P 500 compounded (price only) at 5.8%, in line with its long term returns. GDP has grown at 4.5% on an annualized basis – a faster rate than is generally expected for the next several years.

In many respects the market is the perspective to the economy’s reality. An analogy might be a dog chasing a car. As a child, my parents had such a dog. He was an Irish Terrier and his name was George. Why he was never killed remains a mystery. The car would move forward at a steady speed. George, seemingly mesmerized by the rotating tires, would dart toward them and back. A chart of both the economy and the market would show similar gyrations – with stock prices first above and then below the more sedate, gradually upward-sloping path of the economy.

The fact that there is no magic formula is what makes investing such a challenging profession. All we can do is to make guesses; mine would be that GDP growth, given the retrenchment of the consumer, will be significantly below trend line. On the other hand, remembering Warren Buffett’s admonition that we are victims of our immediate past, stocks, in my opinion, are more likely have a better decade in the one ahead than they did in the previous one.

In many respects the recession of 2000-2001 should have been deeper and longer. A combination of sharply reduced interest rates and a government policy encouraging profligacy in home ownership fueled the economy for another six years, resulting in the financial panic of 2007-2008 and the far worst recession we have just been through. It will take time to exit the economic hole we have dug. But stocks, over time, tend to be anticipatory. Humans tend to be emotional and reactionary; it is that divergence that should provide opportunity to the investor.