The Stock Market and Real GDP

With the recent surge in stock prices, some analysts believe that the probability of recession is receding.


Figure 1 shows the evolution of real GDP and the S&P industrials since 2000.


stocks1.gif

Figure 1: Log real GDP, SAAR,Ch.2000$, (blue) and log nominal S&P Industrials index, last month of quarter (red). NBER defined recessions in gray. Source: BEA NIPA release of 27 September 2007, IMF International Financial Statistics, and NBER.

The argument that higher stock prices would presage faster economic growth makes a lot of sense. Since stock prices are the present discounted value of the future stream of expected dividends, an increase in anticipated economic activity — and hence earnings and dividends — should be associated with a boost in the stock market. In this regard, looking at detrended real output and real S&P industrials is instructive.


stocks2.gif

Figure 2: Log real GDP, SAAR,Ch.2000$, (blue) and log S&P Industrials index, last month of quarter, deflated by GDP deflator. Both series detrended using Hodrick-Prescott filter applied to full sample, using default lambda parameter for quarterly data (=1600). NBER defined recessions in gray. Source: BEA NIPA release of 27 September 2007, IMF International Financial Statistics, NBER, and author’s calculations.

One has to be wary about detrending — in this case I’ve used the Hodrick-Prescott filter, which has its detractors (see e.g., Cogley and Nason, JEDC, 1995). With that caveat in mind, note that in general detrended output follow detrended stock prices.


The notable exceptions include 1987, when stock prices rose, as output fell, and when stock prices collapsed in Black Monday, output rose. Another exception is the run-up to the 1990 recession; in that case stock prices rose relative to trend up until the recession.


Different detrending techniques would probably lead to different results. However, the main (and fairly modest) point is that the stock prices are an imperfect indicator of recessions and booms.


What to think of the most recent rise in stock prices? Returning to the characterization of stock prices as the present discounted value of dividends, one is reminded that the required rate of return on equities is also part of the formula — and the drop in the Fed funds rate is clearly important here. In other words, a lower Fed funds rate, to the extent that it reduces the rate of discount for equities, could mean that stock prices are a particularly misleading indicator of the market’s expectations of the future state of the economy.

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34 thoughts on “The Stock Market and Real GDP

  1. Buzzcut

    What to think of the most recent rise in stock prices? Returning to the characterization of stock prices as the present discounted value of dividends, one is reminded that the required rate of return on equities is also part of the formula — and the drop in the Fed funds rate is clealry important here.
    Bingo.
    Actually, I’m surprised that you posted about the stock market and not the bond market. What is the bond market telling us? 4.56% yield on the 10 year?!? What’s up with that? Where have all the inflation expectations gone?

  2. Rich Berger

    Professor-
    Profits have been growing at a fast pace for years now, and even though the market has risen significantly, the multiples are still not exorbitant (unlike at 2000). At some point, the profit growth is going to stop and perhaps turn negative before resuming its climb.
    I don’t think the “market” is quite so rational as to base value on discounted cash flows, at least in the short term. Speculators seem to view the Fed’s role as the giver or taker of the punch bowl – easing is good, restricting is bad. I think the effects are more complicated than that, given the effects on inflation.
    Using the stock market to predict recession? I don’t think it is reliable. I think Buffet said that in the short term, the market is a voting machine, and in the long term, a weighing machine. I have confidence in the long term weight of equities, but not much in voting. Too many reversals in short periods, like this past summer.

  3. Jake Miller

    What I’ve been reading is that traders are betting on future interest rate cuts from the Fed to get the economy moving, and they’re trying to get in on the market in front of everyone else. This strikes me as a herd mentality that could well backfire, becasue we haven’t seen housing hit bottom, nor has it bled over enough into the consumer (and you have to think it will at some point).
    And with the dollar continuing to plummet along with $80 oil and food prices on the rise here and in other parts of the world, I think the Fed is hoping to be “one and done” with this cut, and won’t do anything when they meet around Halloween. Could be quite the trick played on these people when the Fed keeps things steady on Oct. 31, and if they start to realize that, you may see a lot of people bailing just as quickly as they jumped back in yesterday.
    In fact, if the traders do get what they want with that cut, I think it’s a sign that we are in recession. Either way, I don’t see how this runup sustains.

  4. Mr. Bail Out

    “A lower Fed funds rate, to the extent that it reduces the rate of discount for equities, could mean that stock prices are a particularly misleading indicator of the market’s expectations of the future state of the economy.”
    Now that’s the long description. The short one: Sucker’s Rally.

  5. spencer

    Samuelson famously said the stock market is a great leading indicator, it has forecast 10 of the last seven recessions.
    But on the other hand going all the way back to 1871 the US has only entered one recession when the Y/Y gain in the stock market was more then 10%. That was 1929. But every other recession has been preceded by the stock market gains falling below 10%. But Samuelson is right, stocks have given numerous false signals.

  6. Buzzcut

    10 year is down to 4.53%.
    I ask again: what’s up with that? I thought that the CW was that inflation is the danger, not recession.

  7. DickF

    Buzzcut,
    Rates are lagging indicators. By the time inflation or deflation is manifest in interest rates the monetary value has been changed for 6 to 12 months. What is happening today will manifest about March 2008.

  8. Bill aka NO DooDahs!

    I’m always bemused by people making statements about the stock market going back over 100 years. The S&P 500 index just celebrated its 50th anniverary not long ago, and Dow, bless his heart, was born in the 20th century.
    FWIW, I think that FFR changes, 10YT changes, M3 (or M2) changes, and stock market changes are the four inputs that do best at predicting future “real GDP.” I also am unsure why anyone cares what “real GDP” will be. Why not just turn that predictive horsepower loose on the markets and make money? Occam’s Razor suggests that predicting the market should be easier than predicting the “real GDP” in order to make market decisions (one prediction versus two).

  9. Menzie Chinn

    buzzcut: Regarding your first comment, I think the yield curve is important (obviously, given previous posts), but I’m leaving that topic to Jim H. Regarding your second, the 10 year is under the expectations hypothesis of the term structure the average of expected short term rates over the next ten years; but standard textbook treatments add in a term premium to incorporate risk factors. To the extent that there has been a flight to safety, along with a heightened belief in slower growth (accompanied by lower credit demand) in the near future, the lower 10 year yield can be easily rationalized.

    Bill aka No DooDahs!: Since my main interest is not in making money (otherwise I’d be doing something else besides teaching in a state university), but rather in trying to understand the future course of the broad economy, I’ve really got no alternative. But I agree, it is easier to predict other financial asset prices/returns using another financial asset price, than it is to use a financial asset price to predict a real aggregate.

  10. Buzzcut

    To the extent that there has been a flight to safety, along with a heightened belief in slower growth (accompanied by lower credit demand) in the near future, the lower 10 year yield can be easily rationalized.
    I agree. But it doesn’t gibe with the CW that inflation risk has increased since the 50 bp rate cut.

  11. jg

    Bill, one can make money on the GDP –> stock market relationship.
    There have been nine recessions since 1950. The recessions lasted an average (and median) of 10 months. The stock market dropped an average of 18% (median 19%) during those recessions. From the start of the recession to the stock market trough was an average of seven months (median of six months).
    So, if one can identify when the recession has started, one can short the market as it drops its average/median of 18-19% over the following three-to-four months.
    That has been my interest as I track the ‘real economy’ press releases daily, to identify when the recession has started.
    I need data to keep my wife placated as we sit in SDS (double inverse of the S&P 500).
    I, unfortunately, got into SDS a bit early (March); too bad I had not done my recession –> stock market correction research until this summer!

  12. jg

    I should have written: “…So, if one can identify when the recession has started, one can short the market as it drops its average/median of 18-19% over the following SIX-TO-SEVEN months…”

  13. jg

    The problem with trying to identify when the recession has started is that some of the government statistics get revised big-time after the fact (e.g., employment) or are of questionable validity (CPI: hedonic and substitution adjustments, excluding health insurance from CPI, using imputed rent instead of actual costs paid out for housing).
    Ah, it’s tough trying to make a buck speculating!

  14. algernon

    Prof. Chinn,
    You raise an important, logical question. My impression is that the stock market is being bouyed or floated by an abundance of liquidity both globally & domestically. M2, which had to grow at >6% to maintain the Fed Funds rate at 5.25%, is now growing at 7%–a lot faster than GDP.
    Long-term interest rates are being reduced by Money growth abroad (18% in China) as central banks there buy 10 yr Treasuries (in contrast to our Fed’s buying T-bills & affecting primarily short-term rates.) 10yr Treasuries at 4.5% make stocks appear attractive.
    And of course this should be temporarily stimulative to GDP, but as the money flows from financial assets to consumer goods, prices will rise more for the latter than the former.
    But for the creation of money & credit, I think the market & GDP would be trending down now–because of the housing collapse & the very high level of endebtedness.

  15. Anonymous

    I’m always bemused by people making statements about the stock market going back over 100 years. The S&P 500 index just celebrated its 50th anniverary not long ago, and Dow, bless his heart, was born in the 20th century.
    In fact, we, thanks to the extraordinary work of Alfred Cowles, followed by the Cowles Commision of the University of Chicago, and now the Cowles Foundation based at Yale, can utilize reconstructed stock market data back to 1871. Add the work done by Ibbotson Associates to reconstruct the S&P 500 from 1926 to 1954, and market historians now have a robust data series covering over a 130 years of American equities.
    Interestingly, the aggregate data supports the formal one in that average long term return discounted for inflation is about 6.6% – a figure which does correlate with the nominal growth of GDP over that era.

  16. Rich Berger

    JG-
    It is extraordinarily difficult to successfully time the market. Not only do you have to avoid the drops, but you have to be invested when the market rises. I would suggest that you read (if you have not done so already), Stocks for the Long Run by Jeremy Siegel and A Random Walk Down Wall Street by Burton Malkiel. Note also that Siegel’s book has data on stock returns going back to 1802. These books are essential for investors.

  17. EthanS

    Looking at the second graph, is appears that volatility in the business cycle has been replaced with volatility in the stock markets.
    Why would that be true? And is it good?
    From a risk apportionment standpoint, business cycle volatility may be bigger direct threat to lower- and middle-class workers from loss of employment, while stock market volatility is more of a risk to investors. But, given the rise in income inequality and income volatility, I have to wonder if there stronger follow-on effects that would counter this?

  18. spencer

    I’m always bemused by people making statements about the stock market going back over 100 years. The S&P 500 index just celebrated its 50th anniverary not long ago, and Dow, bless his heart, was born in the 20th century.
    Robert Shiller has compiled an historic stock market index of the S&P Comp that he used in Irrational Exuberance that goes back to 1871.
    If you google him you can go to his web site and download the data.
    Robert Rich — no you do not have to get into the market at the bottom to beat the index.
    If you go into cash near a market peak you are still ahead if you get back into the before the market gets to the point where cash would have you over that interval. In most bear markets this means you can still beat the market even if you miss most of the rebound. For example, if one had gone into cash when the Fed started tightening
    in June 1999 you would still be ahead of the S&P 500 with daily dividend reinvested as of the end of last month.

  19. Rich Berger

    Spencer-
    Forgive me if I don’t put too much stock in Schiller. Since his Irrational Exuberance, market returns have been in line with historical long-term performance.
    I know it is theoretically possible to time the market if you make the right moves, but very few have. Have you?

  20. jg

    Rick, I read those books, and one by Peter Lynch. I studied finance at U. of Chicago, and came out an efficient markets zealot. I solely used index funds over ’92-’04. Then, looking back, I saw that the the tumble in ’01 looked perfectly predictable in hindsight.
    So, I no longer blindly index. I made a lot of money in gold and gold mining stocks over ’05-’06, and am now trying my ‘hot hand’ with shorting the market.
    I may be in for an expensive education!

  21. Rich Berger

    JG-
    Good luck, but don’t lose more than you can afford. If you haven’t read them already, I can recommend Victor Niederhoffer’s “Education of a Speculator” and “Practical Speculation”. After reading those two, I realized that I did not have the right emotional makeup to be a speculator. I also recommend VN’s website – dailyspeculations.com.

  22. jg

    I figure that I’m hedged, Rich: if I’m wrong and all is smelling like roses, I get to keep my well-paying job. But, if this unwinds as I think it will, I’ll have everything that my family and I need from my SDS and gold/gold mining stocks speculation.
    Thanks for the link, too; I’ll check it out.

  23. Mark S.

    I believe that the rapid drop in the dollar exchange rate is the major factor in buoying the US stock market dollar valuation… More robust Euros buy more U.S. equities, and Euro-Dollars eventually have to find a financial home in the United States.
    This activity will continue with the U.S. Current Account deficit in a tailspin, since the foreign dollars have to be cleared through the financial system to some sort of U.S. asset… The Gulf states and China are avoiding U.S. Government debt, preferring equities as an inflation (read: current account deficit) hedge.
    If you take the S&P 500 index, and normalize it with the dollar index, you will find that the real U.S. stock market valuation has fallen over the last several years! (We’re in a recession right now, only CPI gimmickry by the government obscures it).

  24. spencer

    Rich — you do not have to agree with Shiller’s market calls to use his data.
    I’ve made my living for 25 years as a market strategist -now semi-retired–and that included market timing. I was more right then wrong.
    I rank forecasting in terms of difficulty by five categories from most difficult to least difficult.
    1. Exchange Rates
    2. Interest rates
    3. Micro economic variables like auto sales, copper prices, etc.
    4. Macro economic activity.
    5. Stock market.
    My experience is that market timing is a lot easier then than forecasting any of the other things.

  25. Rich Berger

    Spencer-
    I did look at your reference. His conclusions seem similar to Siegel’s: it is extremely difficult to be a successful market timer.

  26. spencer

    I agree that it is difficult.
    Moreover, it also depends on what you are trying to time, short run noise or long run swings.
    It has also gotten more difficult. From WW II to the early 1980s stocks were in a bear market about
    25% of the time — the old four year business cycle.
    But since the early 1980s the great moderation in the economy has also been manifested in the stock market as the time that stocks are in a bear market has been cut in about half to around 12% of the time. Consequently, the odds very strongly favor being fully invested at all times and you better be extremely confident that all your analysis is right before you raise much cash.
    Of course a great deal of the improvement since 1980s has been driven by the point that we have been in a secular bull market in bonds and the market PE. So the most important question for stock market timing may be, has the secular bond bull market ended.
    The drop in the frequency of bear markets was a major component of the rise in market valuations in the late 1990s. But now the relationship between interest rates and the market PE has returned to where it was in the 1960-95 era, implying that the market expects bear markets to be more frequent in the future then the have been since the early 1980s.

  27. Buzzcut

    The Gulf states and China are avoiding U.S. Government debt, preferring equities as an inflation (read: current account deficit) hedge.
    Is this true?
    10 year yield is 4.53% at this point in time. Dow is slightly under 14k.
    I think that the Chinese and Arabs are back to buying T-bills. How else can you explain these low rates?

  28. jaim klein

    ….stock prices are the present discounted value of the future stream of expected dividends…
    If it only was so simple… No risk for Prof. Menzie ever to get rich on the stock market…

  29. Menzie Chinn

    jaim klein: I’d say this characterization is anything but simple. One has to look at market expectations, and one has to look at the required rate of return on equities, which might incorporate a risk premium, which evolves over time.

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