Market Is Telling Us the Economy Is More Productive Than We Thought

The stock market is now trading near all-time highs. People know this but don’t pay much attention because they mistrust the market. Its daily ups and downs seem driven by greed, fear, rumor and herd psychology. It’s gambling, not economics.

Wrong. Just because the market is erratic doesn’t mean it has no significance. In fact, it’s sending an emphatic message about the 1990s: American business is far more productive and profitable than most people think.

Unless all investors are crazy, stock prices ultimately reflect current business profits and expectations of future profits. What’s propelled the market’s insistent rise in the 1990s has been the decline of inflation (which makes a dollar’s profit worth more) and the growth of profits themselves. Consider: between 1983 and 1988, after-tax profits for the companies in the Standard & Poor’s index of 500 stocks increased 60%.

By itself, the latest market rally, which sent prices over their previous record on August 24, is not important. What matters are long-term trends. Here, the decade’s performance is impressive. Since 1980, prices of stocks traded on the New York Stock Exchange have nearly tripled. This is the biggest increase since the 1950s. Paradoxically, the 1980s (unlike the 1950s) were a period when U.S. companies faced enormous competitive pressures from foreign companies, takeover threats and deregulation.

Corporate America got a dose of reality therapy in the 1980s. In effect, the market is saying the therapy worked. All those pressures forced companies to make themselves more efficient and profitable. The profits recovery is especially good news for a couple of reasons.

First, strong profits are one sign that companies are competitive. They can cover their costs and earn a decent return on their investments. Profits are also an important source of corporate funds for new investment. Economist Richard Kopcke of the Federal Reserve Bank of Boston reports that corporations finance about three-quarters of their new investments themselves, as opposed to borrowing or selling new stock.

The second reason to cheer good profits is that they mean stock prices today don’t look nearly as suspicious as they did in the late summer of 1987, just before the terrifying crash of October. Stocks were selling then at prices nearly 22 times company profits, which was well above average for the postwar period. Today, stock prices are about 12 to 13 times earnings. This is much more in line with historic experience.

Please don’t misconstrue any of this. It’s not stock market advice. I’m trying to explain a general trend, not the market’s latest blip. I don’t know whether the market will go up or down. I agree that the market can--for short periods--get caught up in fits of speculative optimism or unrealistic pessimism. Compounding this general moodiness is genuine uncertainty about the future. What will happen to inflation? Will there be a recession? If so, how severe? What will happen to profits?

I don’t know the answers. No one does. In this sense, the stock market’s daily changes reflect ongoing gambles about the future. But I am also saying that the analogy of stock market to casino is too glib. It ignores the reality that the market’s performance also reflects underlying economic trends. In the 1950s--a period of strong growth and low inflation--the market more than tripled. In the 1960s--which had strong growth but rising inflation--it almost doubled. In the 1970s, it advanced only a quarter, much less than the decade’s inflation of 57%.

So don’t dismiss the 1980s’ sharp stock market recovery as a fluke. All those competitive pressures were unpleasant. But they forced companies to sharpen themselves. They--and the economy--are a lot stronger now than a decade ago.