The markets give us a sense of security just by what a number or graph tells us. Most people base their future off of the stock market; whether it is for retirement or the paycheck that puts food on the table for tomorrow. So little is known about the stock markets and how they work, but so much is pursued by the hope of eternal wealth. The fluctuation in the market is determined so much by economic news or news that is broken about the company. We generally consider profits to be good news but sometimes we take it as bad news. By that I mean that Google may report earnings of 10.6 billion dollars and 2.7 billion dollars of earnings on those revenues and the public perceives it as a bad thing. Just because they didn’t meet the expectations of experts we see 2.7 billion dollars of profits as mediocrity. Their stock in turn fell 9% in after hours trading as a result. Since the wealth of a nation as determined by gross domestic product is determined partly by the wealth of its people, one would think that greater marker returns would result in greater wealth of the nation.
For my regression I used the Dow Jones Industrial Average and Standard & Poor’s 500 yearly returns in comparison to the growth percentage of gross domestic product. For this comparison most would think you would compare the current years return in the stock market to the current year’s growth or contraction of growth domestic product. But, I am using the previous year’s earnings in comparison to the for the next year’s growth in gross domestic product. I am using this because I am using the assumption that people are more inclined to spend if the previous year’s returns are higher as opposed to lower. By looking at the table you can simply see the numbers do not perfectly correlate. This makes the question come to mind of how much they really do have in relationship to each other.
Year| Annual GDP Growth %| DJIA % Returns| S&P 500 % Returns| Year|
1977| 4.60%| 17.86%| 23.84%| 1976|
1978| 5.60%| -17.27%| -7.18%| 1977|
1979| 3.10%| -3.15%| 4.01%| 1978|
1980| -0.30%| 4.19%| 6.56%| 1979|
1981| 2.50%| 14.93%| 32.50%| 1980|
1982| -1.90%| -9.23%| -4.92%| 1981|
1983| 4.50%| 19.61%| 21.55%| 1982|
1984| 7.20%| 20.27%| 22.56%| 1983|
1985| 4.10%| -3.74%| 6.27%| 1984|
1986| 3.50%| 27.66%| 31.73%| 1985|
1987| 3.20%| 22.58%| 18.67%| 1986|
1988| 4.10%| 2.26%| 5.25%| 1987|
1989| 3.60%| 11.85%| 16.61%| 1988|
1990| 1.90%| 26.96%| 31.69%| 1989|
1991| -0.20%| -4.34%| -3.11%| 1990|
1992| 3.40%| 20.32%| 30.47%| 1991|
1993| 2.90%| 4.17%| 7.62%| 1992|
1994| 4.10%| 13.72%| 10.08%| 1993|
1995| 2.50%| 2.14%| 1.32%| 1994|
1996| 3.70%| 33.45%| 37.58%| 1995|
1997| 4.50%| 26.01%| 22.96%| 1996|
1998| 4.40%| 22.64%| 33.36%| 1997|
1999| 4.80%| 16.10%| 28.58%| 1998|
2000| 4.10%| 25.22%| 21.04%| 1999|
2001| 1.10%| -6.18%| -9.11%| 2000|
2002| 1.80%| -7.10%| -11.89%| 2001|
2003| 2.50%| -16.76%| -22.10%| 2002|
2004| 3.50%| 25.32%| 28.68%| 2003|
2005| 3.10%| 3.15%| 10.88%| 2004|
2006| 2.70%| -0.61%| 4.91%| 2005|
2007| 1.90%| 16.29%| 15.79%| 2006|
2008| -0.30%| 6.43%| 5.49%| 2007|
2009| -3.50%| -33.84%| -37.00%| 2008|
2010| 3.00%| 18.82%| 26.46%| 2009|
2011| 1.70%| 11.02%| 15.06%| 2010|
When you crunch the numbers and run your regression you can tell by the R square that the DJIA has a 28.11% correlation to the gross domestic product. For the S&P 500 we see that the relation is slightly higher at 31.99%. This does indicate that market returns does have a relationship with the economic growth of gross domestic product. Even though it is not a strong correlation it can still be used as a tool with other indicators to help predict the gross domestic product for the following year.
The first article I read was put out by two men (Rajiv Jain and Daniel Kranson) whom work for Vontobel Asset Management Inc. Based on their opinion; the stock market returns have absolutely no effect on the estimations of gross domestic product. The interesting thing to me is that they used the previous year’s returns in relation to the same year’s growth of gross domestic product. When you run a regression on those numbers it does strongly indicate that there is very little relation between the two. I however believe that it should be the previous year’s returns compared to the following year’s gross domestic product growth. I believe this for a couple of reasons. First of all, many people may be aware of what the market is doing, but many people are not aware of what their money did until they see the year’s end gain or losses. If they see a substantial growth in their money it should give them a greater sense of security which in turn should lead to more spending the upcoming year. Second, the opposite should also hold true if they see smaller returns or even losses. Smaller amounts of spending should happen in the subsequent year.
Financialphysics.net had an interesting and different approach to looking at how market returns affect GDP growth. It used the comparison of seeing the affect returns from the market had on the interest rate set by the Fed. The interest rate then was used as the driver of GDP growth or contraction. In this case market returns are seen as an externality. This scenario seems to put a much greater importance on how the market performs. Too much importance as determined by the regression I ran. I find one statement very interesting, “As business revenues grow, business earnings grow, and GDP grows (Rao)”. The statement sounds perfectly honest and true, but I only see it as having only partial truth. As businesses grow they do make more money, but that could therefore lead to one of its competitor’s downfall. As they say, one man’s gain can be another man’s loss. In result, that would cancel the money earned out.
Geert Bekaert of Stanford University and Campbell Harvey of Duke suggest that through research the stock market has some but little correlation with the growth of the economy. Their reasoning is backed by the statement that “managers typically have more information than outsiders” (Bekaert, and Harvey ). They say managers only issue new equity if they have the need and feel as if it is overpriced. Their point of view is also back by the cause of moral hard. Basically, they are questioning the fact that managers are in it for their compensation and not in it for the interest of the shareholders. While this may be true, many companies avoid this problem by setting managerial compensation packages that will benefit the shareholders. This must be done or an investment in that particular company does not look very auspicious.
The Bank of Valletta did their own research to try to solve the unending debate of whether the stock market is a reliable indicator of what GDP will be. Like many others, their data really didn’t show much for either side. Ultimately, they concluded that stock market returns could potentially be a driver in GDP. This seemed like a very conservative approach to the topic. Bank of Valletta says that the stock market must be consistent in for this to really be a backing force. As we all know, the stock market is hardly consistent. It is more or less consistently inconsistent. The markets may give an average annual return of 10.53% over the past 36, but the actual annual return deviates around that number greatly.
Hui Guo of the Federal Reserve Bank of St. Louis did a research over how the shock rates of market returns influenced the GDP growth. He in turn found that when the market had a shock, a major increase or decrease, that GDP only subtly responded to it. In times of large stock market return movements, GDP did not largely reflect the move. He argues that there was just as much fluctuation in GDP during so called times of consistency. While it may be a stretch to say that is always the case, his evidence does hold to be true in some instances. The largest inverse shift as shown by his data was in late 1980’s when the stock market was having large returns and GDP was going down largely in comparison.
There is no clear cut answer to this ever ending debate. Most of the data suggest that the market is not a good indicator of future economic growth. It all depends on how you run the numbers and perceive the data. The actual debate on this topic is relatively young in comparison to how long the stock market and GDP calculations have been around. Most of these did not start happening until the past 20 years. This made it more difficult to find data seeing as how the debate has really just begun. But, no matter which side of the fence you stand on, it is agreeable that time will tell.