The Stock Market and Arithmetic
by Arnold Kling
February 14, 1997
There are a million ways to look at the stock market. I was trained to use accounting and
arithmetic.
Here are some facts about corporate profits, national income, and
stock prices.
National Income, Corporate Profits and Stock Prices, Total
Increase
Time Period | National Income | Corporate Profits | Dow Jones Industrial Average |
1959-1977 | 394 % | 333 % | 142 % |
1977-1996, Q3 | 384 % | 395 % | 636 % |
1959-1996, Q3 | 1511 % | 1317 % | 899 % |
(Source: The
Economic Report of the President, 1997. Data available through third quarter (Q3) 1996)
Some observations:
-
Taking the period as a whole, stock prices have not gone up faster than
corporate profits. Broader stock market indexes, such as the S&P 500, have
gone up faster than the Dow, but still not quite as much as corporate profits.
- Corporate profits are a component of national income. Other components include labor compensation (the largest component) and
income of unincorporated businesses. The ratio of corporate profits to national income is called the
share of profits in national income.
- Over time, corporate profits tend to grow at about the same rate as national income. When
corporate profits grow more slowly, as they did from 1959-1977, the profit share declines
(this is purely a matter of arithmetic). When corporate profits grow more quickly than national
income, the profit share increases.
- One might think that stock prices would tend to move with corporate profits (after all, shares of
stock are shares in the earnings of corporations). However, in the 1970's,
stock prices rose dramatically less than corporate profits. In the 1990's
stocks have gone up much more rapidly than corporate profits.
Looking at the future, it is much easier to predict national income and corporate profits than it is
to predict stock prices. National income is likely to grow at about 5.5 percent, give or take a couple of
percentage points. This is based on an assumption that inflation will be
about 3 percent and real growth will be about 2.5 percent, for
a total of 5.5 percent.
Corporate profits probably will grow at about the same rate as national income. This is not what
we have seen in the past four years. From 1992 to 1995, profits grew at a 13.5 percent annual rate, compared with
5.5 percent for national income. This boosted the share of profits in national income from 8.1 percent to
10.1 percent. 1996 data were not yet complete as this was written, but it is very likely that the share of
corporate profits took another jump of at least 1/2 of one percent.
The bottom line is that the most probable outlook for corporate profits
it that they are likely to grow at "only" 5-6 percent
in the next several years. This is very nearly a matter of arithmetic.
Suppose instead that for three more years profits grow13 percent and national
income grows 5.5 percent. This would bring the profit share up above
13 percent, with
the shares of workers and small businesses falling. This is possible, but not
nearly as likely as a scenario in which income shares remain stable.
What does this arithmetic mean for stock prices? In the short run, it
probably means nothing.
- In the late 1970's, with inflation in double digits and other economic woes,
everyone "knew" that stocks were a bad investment. I was in graduate school at the time,
and one of my professors, Franco
Modigliani, looked at the accounting and arithmetic and decided that stocks were
a great buy. Stocks continued to perform miserably for four years.
- Eighteen months ago, I pointed out that the "dividend yield"
on real estate was higher than that on stocks. Stocks have
dramatically out-performed real estate since then.
Many observers believe that stocks will continue to go up at double-digit rates.
They may be correct.
However, the way the arithmetic looks to me, profits are not going to
rise enough to validate such increases.
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