Stock market returns, inflation and GDP / by kevin murray

During our current bull market, the Dow Jones Industrial Average (DJIA) appears to set a new record almost every day, but numbers can be quite deceptive, especially when those numbers are not constant in value, which is the case w. the DJIA and the stock market, because these markets are denominated in dollars, which change in worth every day.  Because of inflation, even moderate inflation, the DJIA should go up over time and historically it has gone up over time as any stock market chart will clearly show you, but if inflation is 2% and your investments only go up 2%, you haven’t done any better than treading water, or in actuality you have probably lost a little money because capital “gains” are taxable.  In all likelihood, however, during this current bull market, you have done much better than 2% on an annual basis and therefore your assets have gone up in tandem.


It is quite misleading though to take a number that has doubled, for instance, and to assume that means that your investment has doubled in real monetary value.  While there isn’t any doubt that mathematically your investment has doubled, because of inflation your investment return depending upon the length of time you have owned it is far less robust that you might imagine.  That is why it is specious to state that historic stock returns are 6.73% (for example) without taking into account the inflation that has occurred over that same period.  To fairly judge how good or how bad stock market returns have historically been, inflation has to be taken into account.


Once inflation is taken into account the DJIA return is far less impressive with arguing that the real return of the DJIA since 1910 is 1.9%.  To make matters even worse, none of this takes into account human proclivities to buy equities when then should be selling them and to sell equities when they should be buying them.   More to the point, the DJIA has its market cycles in which the ups and downs can be quite significant and break the investing resolve of even the staunchest investors, even over relatively short periods of time.


So thereby we are left with a relatively miserly real return of somewhere around 2% and not the eye-popping true double digits we hear so much about. Further thought demands and implies that when it comes to stock market returns that there should be a very close correlation between real GDP growth and real stock market returns, in which from the years 1947 through 2013 the real GDP growth in America as reported by was 3.24%.  For that same period of time, the DJIA inflation-adjusted return was approximately 3.36% so that this correlation is indeed very close.


Therefore it would appear that the stock market reflects over time, the inflation-adjusted gross domestic product of the United States.  This makes sense, because the DJIA should mirror back to us the combination of stock earnings both past and projected, and the goods and services produced by this country on a yearly basis.  Consequently, real GDP growth and its trend line will be the ultimate determining factor of the stock market.