Thinking Things Over October 21, 2011
Volume I, Number 14: Want to Fix the Economy? Fix the Stock Market
By John L. Chapman, Ph.D. Washington, D.C.
An old adage in the investment business posits that “the economy is not the stock market, and the stock market is not the economy.” Like all such aphorisms, there is some truth in saying this, to an extent: indeed, equity markets can move for an extended time in seemingly no correlation with the broader economy. For example, when the Dow Jones Industrial Average reached an all time high of 381 on September 3, 1929, it began a three-year descent, wiping out 32 years’ worth of prior gains by the summer of 1932; it did not reach 381 again until November 25, 1954, twenty-five years later. Yet industrial production reached 1929 levels by 1939, and the economy grew progressively after the war years by 3.5% per annum. So much so there was, except for several months in 1946, no problem in re-absorbing 16 million men and women in uniform back into the civilian economy in the United States by 1947. Likewise, between 1966 and late in 1982, in between 1000-point plateaus, the Dow was flat to down upwards of 30% nominally, and 70% in inflation-adjusted terms. Yet the economy grew at roughly 2.5% per year in real terms across that time-frame.
Conversely, the opposite trend can be in play as well: the market quadrupled in the five years after the summer of 1932, and was up nearly 80% between March 2009 and this summer, yet in both cases economic growth and job creation were anemic by comparison.
But in the long run, spanning decades, it is evident from the data that healthy growth in real GDP and U.S. equities go hand in hand, as logic impels. And further, that when the dollar’s value is dependably-valued and not subject to political manipulation, stronger real growth in GDP is matched by the same in equities. The volatility in the trade-weighted value of the U.S. Dollar stunts, but does not eviscerate growth (thanks to the perpetual genius of America’s entrepreneurial business professional class), but it does sometimes obscure this long run link between the stock market and the real economy because of confusion regarding nominal values of the Dow (expressed in those dollars). Nonetheless, it is axiomatically true that there can be no sustainable recovery to growth and economic progress without a vibrant market for U.S. corporate equities, that are systematically increasing in real terms over time.
President Obama has fed the myth of a disconnect between financial markets and the real economy by dismissing this truism on more than one occasion, stating that the stock market was “like polling in politics” that went “up and down”, and that involved “gyrations” that one should pay no heed. Unfortunately, in terms of apprehending the role and importance of equity markets, which are truly the heart and circulatory system of a market economy, this is as naive as it is incorrect. Examining the history of U.S. equities when considered against GDP growth illuminates this, and suggests the best pro-growth policies moving forward.
The first chart here below shows the S&P 500 going back to 1957 in an equi-proportional log scale. The chart is interesting when considered against U.S. economic history in that time: U.S. equities were in a bull market from the mid-50s through much of 1966, rallying strongly out of the short recession of 1957-58. But the inflation that began after 1966 and in the 1970s reached the highest levels in the U.S. since the Greenback Era of a century earlier resulted in very uneven real growth, and a choppy sideways stock market in nominal terms. High and variable inflation, caused in the 1970s by the Fed’s stop-go monetary manipulation after Nixon’s abandonment of gold in 1971, is detrimental to both real growth and real value creation in equities, because if investors cannot feel confident about the dollar’s future value, they pull back from investments involving risk capital. The graph shows the tragic outcome of LBJ-Nixon-Ford-Carter monetary disregard: the S&P index was back to the same level in late 1982 as it had seen in 1966.
But the story is a much happier one for the nearly two decades between 1982-2000. An almost non-stop bull market, punctuated by a short recession in 1990-91, led to a 13x-increase in the S&P 500 Index. This era was marked as well by a generally strong dollar policy during the Volcker and first half of the Greenspan Feds, and a real economy that grew 3.7% annually during that span.
Note however that since the market peak in 2000, there has of course been another bust-boom-and-bust-boom which, like the 1966-82 period, is indicative of a vacillating dollar, that is to say, a weak dollar that has lost 21% of its trade weighted value in the new century. Economic growth has been a paltry 1.7% per annum in the last ten years, and this is an important lesson: equity markets and GDP growth are both optimized by a dependably-valued currency, as in the 1980s-90s. Conversely, in the 1970s and again in the 2000s, a weak dollar and profligate fiscal policy combined to produce sub-par growth and poor (zero nominal) equity returns.
This point — and the policy lesson it contains — is much more visible when inspecting the next graph, from Approximity, showing the Dow Jones Industrial Average mapped against the dollar price of gold dating to 1885:
Chart II. Dow Jones Industrial Average/Dollar Price of Gold (1885-2011)
If we look at this second chart from 1957 up to the present, we see a very different graph than the one above. But one which makes the same point, and makes it more effectively due to the nominal monetary aggregate — derived from a government-managed fiat dollar post-1971 — shown as linked (“normalized”) once again to the intrinsically-valuable commodity of gold. That is, in the second graph above, we see a long decline from 1967 through 1982, and again from 2000 to the present, whereas in the first chart we see boom and bust across what is ultimately a long period of a sideways or flat market.
And more to the point, note especially the startling difference between the two charts from 2000 to the present: in the first chart, the S&P declines from 2000-2002, rallies back between 2003-2007, collapses back down from the end of 2007 through the spring of 2009, rallies back up through most of this July, and now has fallen again in the last few months. By contrast, in the second chart, when measured against gold, the Dow has fallen consistently now for 11+ years.
What’s the significance of this? Only that the second chart is the more honest one, because it accurately depicts a depreciating dollar and extremely weak real economic growth. Indeed, this second chart, which normalizes the equity index against the dollar price of gold, is an excellent real time indicator of the health and vibrancy of the U.S. economy because it “corrects” for the false signals emitted by a fiat currency that falsifies nominal magnitudes. And indeed, in the last 11 years, the U.S. has suffered with zero net new job creation even as there are now 33 million more Americans than there were in 2000, along with declining real incomes and a sub-2% growth rate barely half the long term historic average for GDP growth in the U.S. .
From the very beginning of his Administration, Mr. Obama has shown an antipathy for those who make their living in banking and investing — that is to say, those engaged in the business of risk acceptance or intermediation in order to move scarce resources to their best uses, and in order to satisfy the wants of their fellow man. So it comes as no surprise that he has no concern for the Dow Jones Industrial Average. But the second graph above is a perfect summary, indeed, an indictment, of the anti-capitalist policies of both his Administration’s and those of his predecessor. And until that graphic’s trend is reversed — until the dollar firms against gold because U.S. equities are once again solid targets for risk capital — the U.S. economy faces long-term headwinds, or what might be more accurately called sclerosis. Fortunately, better policies to induce saving, capital accumulation, and new investment that in turn will encourage new job creation, higher levels of productivity, and greater output are merely a choice away. As always, a stronger dollar and capital-friendly tax policy will ensure a future far brighter than the recent past.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at email@example.com.
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