In February we saw headlines about the Dow Jones Industrial Average reaching its highest level in nearly four years, eventually surpassing the 13,000 mark. A few media outlets were optimistic that it would rise to its all-time peak. Others suggested that, considering the speed and magnitude of the recent gains, a pullback could be imminent.
Conventional wisdom questioned how stocks could be so high when the economy was still widely perceived to be in a funk. In my opinion, the real wonder was why stocks hadnâ€™t already gone to new highsâ€”because the economy was already well on its way.
You read that statement correctly. Despite all the headlines and the real problems we haveâ€”unemployment, the European debt debacle, the housing crisisâ€”the U.S. produced more wealth last year than ever before. First weâ€™ll put numbers to the story and then examine why stocks and the economy arenâ€™t always in sync.
Letâ€™s focus on the economy and stocks over the last five years. The size of an economy is measured by its gross domestic productâ€”the market value of all the goods and services it produces in a year. In 2006, the GDP of the United States was $13.3 trillion. Last year it set a record, an estimated $14.8 trillion. Over that five-year period, GDP cumulatively grew approximately 11%, but it never changed more than 5% in any one of those years and fell only onceâ€”a 1.7% drop in 2009. The stock market, represented by the Standard & Poorâ€™s 500 Index, told a very different story. Since the end of 2006, the S&P 500 has been flat for the whole period, but made massive shifts in-between. In three of the five years, it posted double-digit moves, losing 37.0% in 2008, gaining 26.5% in 2009, and rising 15.1% in 2010.
So thatâ€™s the conundrum: If the economy and stock market are connected, how can one go up fairly smoothly more than 10% over a half-decade, while the other jumps all over the place but ends up going nowhere? After all, when you buy stock in a company you hold the right to the profits the business generates. And the S&P 500 Index does contain 500 of Americaâ€™s biggest businessesâ€”so if the economy is doing well, those companies are, too.
But as legendary value investor Ben Graham wrote in The Intelligent Investor (Collins Business; $21.99): â€śThe stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.â€ť His point is not that the market only tracks sentimentâ€”fundamentals will win out over the long term. In the short term, however, stocks are heavily influenced by emotion, opinion, and so forth. So while a mature economy like ours rarely grows or shrinks more than a few percentage points a year, the stock market often makes double-digit moves.
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