GDP growth and the S&P 500 in historical perspective

August 11, 2006

Holdings

	Aug-06
1	F
2	NBG
3	PCLN
4	NKE
5	BA
6	VRSN
7	SNP
8	CAT
9	INTC
10	C
11	TOA
12	FNF
13	MS
14	TKC
15	HMC
16	CRYP
17	X
18	DOW
19	COP
20	ACH

Performance of Individual Stocks For last 3 months:

Aug-06
FNF	-9.23%
COP	3.37%
CAT	-15.45%
NKE	-5.54%
BA	-13.56%
VRSN	-25.48%
SNP	-9.85%
PCLN	7.06%
INTC	-9.60%
C	-2.73%
CA	-12.08%
F	4.24%
MS	2.15%
TKC	-13.15%
HMC	-6.53%
CRYP	-16.63%
X	-23.27%
AAPL	-6.60%
NBG	-20.20%
ACH	-30.75%

Total Increase (Decrease) since last quarter: -10.19%

Additions: TOA, DOW

Subtractions: CA, AAPL

Commentary: Merhaba from Istanbul.

My commentary this quarter is on the US economy. If you have never looked in detail at the US economy and US stockmarkets, I hope this quarterly commentary will be especially enlightening. There are two main takeaway points. First, the US economy and stockmarket have not grown nearly as fast as people think it has over the last 75 years. Second, much of the appreciation of the price of the US markets has been due to appreciation in the multiple of price to earnings at which ‘investors’ have been willing to pay for US stocks[1].

As a starting point, let’s look at the growth of the US economy since 1929.[2] The following two graphs are very informative. The first shows the exponential growth of the US economy:

Take a minute to think about the above graph. It is amazing. It is probably the single most impressive feat of economic growth in the history of the world.[3] In dollar terms, the American economy expanded from $103 billion to a whopping $13.2 trillion! This represents an increase of 128 times. However, much of this ‘growth’ is actually due to inflation. The pink line above shows this. Accounting for inflation, the US economy expanded by a factor of 10.4. Still big, but not nearly as big as 128[4].

The following chart shows the evolution of the Consumer Price Index (CPI) in the USA since 1929

So, of all factors contributing to the growth of the US economy and stockmarkets in absolute terms, inflation is the largest one! Inflation has risen by a factor of 11.1 since 1929. It was especially pronounced during WWII and the postwar years, and also the 1970s.

Another major factor in this growth has been demographic expansion: The population of the USA grew from 122 million in 1929 to 300 million by the end of 2006.[5] If population growth and the CPI are taken into account, then the growth of the US economy per capita is not quite as impressive as the following chart shows:

The chart above shows that the average person today can buy about 4.5 times the amount of stuff as someone in 1929 could[6]. That is still really impressive growth, but it represents a compounded annual growth rate in GDP per capita of just about 2 percent per year.

Now, let’s look at the performance of the S&P 500 over the same time period. Like GDP growth, in absolute terms, the growth is impressive: rising 51 times from 24.86 to 1278[7]. Accounting for inflation however this is an increase is just a bit over 4 times, or a compounded annual growth rate of just below 2 percent. This is shockingly low for most people who haven’t seen this data before. In other words, if inflation protected treasury securities had existed back in 1929, and if you were guaranteed a spread of 200 basis points above inflation, you would have been equally well off investing in these government bonds as you would have been investing in the S&P 500. Wow!

Another way of describing this data is that accounting for inflation, the S&P 500 actually underperformed the growth of the general US economy over the time period looked at. The following chart demonstrates this:

Of course, the above chart is somewhat misleading, because dividends are not taken into account. I’m not sure what the average dividend payout of the S&P 500 has been over time, but my guess is that it’s been somewhere around 2-3%, so with dividends the return on the S&P 500 may have been slightly higher or about equal to the return on the nation’s GDP. Nonetheless, that the two datasets are closely correlated seems to suggest that the stocks in the US correlate somewhat with GDP growth. The following chart shows the two datasets together with an estimated 2.5% annual return on S&P dividends:

I’m not sure if the 2.5% per year annual dividend is a reasonable estimate to use. So, perhaps the pink line above representing S&P 500 annual returns should be pivoted a bit higher, or perhaps it should be pivoted a bit lower. Nonetheless, over the long run, there seems to be a reasonable correlation between the return on the S&P 500 and the GDP, adjusted for inflation and dividends. It should also be noted that at several occasions, the lines crisscross. So, what causes these oscillations? The following graph is very interesting

The medieval analogy of the wheel of fortune whirling around its unmoving center is particularly appropriate here. Since the 1970s, much of the change in value of the S&P 500 index has been due to changes in the PE multiple at which the market is willing to own the index. In other words, little of the appreciation of the S&P 500 is due to real improvements in earnings, once inflation is taken into account.

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