What goes up, must come down, Spinnin’ wheel, got ta go round. Talkin’ ’bout your troubles it’s a cryin’ sin, ride a painted pony, let the spinnin’ wheel spin. I can’t believe that I have not used the lyrics to this 1969 Blood, Sweat & Tears song. David Clayton-Thomas, the band’s lead vocalist write the song as a way of saying Don’t get too caught up, because everything comes full circle.
The popular press tends to equate the rise and fall of stock market indices with the rise and fall of the economy. If the Dow or the Nasdaq are rising then the economy must be doing good. On the other hand, if the indices are falling the economy must be doing poorly. It’s easy to understand why, with a 24-hour news cycle and thousands of outlets looking for something to report on in a timely matter, the media will focus on stock markets. Market data is available real-time and stock markets can rise and fall rapidly during a single day or week, providing a lot of opportunities for reporters to speculate and for outlets to post emotional video and pictures of traders.
But in the short and medium term stock markets have virtually nothing to do with the economy. At best, they reflect on the relative value of international currencies, while at worst they measure nothing but heard emotions. That is why bubbles form around individual stocks and even entire markets, the rise and fall of these bubbles is why markets are so volatile.
The Nasdaq index peaked in March of 2000 at about 5,050. This was the height of the dot-com bubble. Following this peak, the index fell by 76 percent to a low of about 1,210 in October of 2002. The dot-com bubble reflected a 600 percent increase in the Nasdaq index during a period of time when the actual economy grew by just 23 percent. This comparison alone shows with little doubt that stock market indices do not reflect the economy.
There was big stock market news this month as the Nasdaq approached the 2000 peak, reaching a high of 5,026 on March 20. This means that the index is up by a lowly 288 percent since the last low in 2009. Over the same period, the US economy has grown by about 11 percent. In other words, the growth in the Nasdaq index over the past 6 years relative to the economy was similar to the growth during the 5 years of the dot-com bubble.
The popular press has been spinning this rise claiming that it is nothing like the dot-com bubble. Pundits claim that one cannot compare Apple with Toys.com, and that the Nasdaq is not trading at the same 200 percent premium to the broader market that it was in 2000. But a bunch of made up financial statistics, and claims about individual companies does not make up for the fact that nothing, not Apple, not gold, not oil, and not the Nasdaq can grow much faster than the overall economy over the long run.
The Nasdaq was founded by National Association of Securities Dealers (NASD) in 1971 and was based on computer systems developed by none other than Bernard Madoff. It opened with 50 companies and an index value of 100. Since 1971, the economy has grown by about 1,390 percent in nominal terms (in other words including inflation). Over the same period, the Nasdaq is up by 4,900 percent (again in nominal terms). In other words, this market has grown by 3.5 times the rate of the economy in the long term.
Market indices should grow at a faster rate than the general economy because they have a built in selection bias. Poorly performing companies drop out of the market and strongly performing companies grow as a percentage of the index value. But should an index grow at 3.5 times the rate of the economy? This is the question that investors must always worry about. Were this growth to be constant, over 230 years, the stock market index would overtake the entire size of the economy. So it is obvious that over the long term, stock markets cannot grow faster than the economy. The Nasdaq has grown 50 percent faster than the rate of the economy since its inception. If this seems reasonable, then there is not a bubble in the stock market. But if it is not, then like the spinning wheel, what goes up, must come down.