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.