Does the stock market tell us anything about the economy? The stock market seems to react continually to various data and economic news, and many of us follow its day-to-day changes, especially if we’re invested in it. But do fluctuations in the stock market actually reflect economic health?
The best measure we have for measuring total economic activity is GDP. But GDP is measured only quarterly and with a considerable lag. With the help of FRED, though, we can look at a decade’s worth of data to see how closely GDP relates to the stock market.
The graph above looks at quarter-to-quarter percent changes in the Dow Jones Industrial Average (DJIA), deflated to remove general price increases, and real GDP, which is by definition also deflated to remove general price increases. Of course, the stock market is very volatile, but it’s too hard to see any relationship in this line graph. A better way to visualize connections (or a lack of connections) is a scatter plot, shown below, with the same data.
If the two measures were related, we would see the points clustered in the lower left, middle, and upper right. But we don’t see that. One reason may be that the DJIA covers only 30 firms. While they’re large firms, they make up only a fraction of the economy. So we built the same graph (below) with data from the S&P500, which encompasses the 500 largest firms on the stock market, and then the Russell 3000 index, with more firms and a longer sample period. But no luck: We still don’t see any relationship.
So why are GDP and the stock market graphically unrelated? First, it’s important to understand what the value of a stock measures: the sum of discounted expected dividends plus a liquidation value of capital. In other words, what the market thinks the future dividends of the firm will be, evaluated at current prices, and what could be obtained from liquidation if the firm goes bankrupt. Note that dividends are only a small part of the firm’s income; dividends don’t account for any income that’s directed toward taxes, servicing loans and bonds, and (maybe most importantly) wages. The labor income share of total income in the economy is about 60%. And, as recently noted on this blog, the labor income share has decreased. Now, if regulation or laws reduce the bargaining power of labor, for example, labor income decreases, capital income and dividends increase, but total income may not have changed or even decreased.
How these graphs were created: LSearch for “Dow Jones,” select the Industrial Average series, and click on “Add to Graph.” Click on “Edit Graph,” add the “GDP deflator,” apply formula a/b, and set units to “Percent change.” From the “Add Line” tab, search for and select “real GDP,” and set units to “Percent change.” Once you restrict the sample to the last 10 years, you have the first graph. For the second, take the first, use the “Edit Graph” panel to open the “Format” tab and select type “Scatter.” For the third and fourth graphs, replace the DJIA with SP500 and Russell 3000. You can then expand the sample.
Suggested by Christian Zimmermann.