Stocks and the Economy, Again
By Arnold Kling
Every few years, I have this argument with a new round of commenters.
The ratio of stock prices to earnings is P/E.
The ratio of earnings to GDP is E/Y.
The ratio of stock prices to GDP is P/Y, which equals P/E times E/Y.
(Note that the basic math here uses stocks that turn all of their earnings into capital gains, paying none as dividends. Including dividend payouts makes the story more complex, but does not change the economic analysis.)
For stock prices to grow faster than GDP, either prices have to grow faster than earnings or earnings have to grow faster than GDP.
Stock prices certainly can rise faster than GDP for long but finite periods. If the P/E ratio starts at about 5 and gradually rises to about 25, that will do it. Something like that happened in the 20th century. Also, if earnings of shareholder-owned companies start at less than 10 percent of GDP, then they can grow faster than GDP for a long time.
Looking forward from today, which do you think is going to happen? Is the P/E ratio going to go up, because people become more willing to hold stocks? Or is the share of national income that goes to shareholder-owned companies going to go up? If you have a good story for one of those two happening, let me know.
(For example, one story is that U.S. firms will earn increasing profits overseas. I do not think that this will be a big enough effect over a sufficiently long period of time to drive earnings growth much above GDP growth. Still, it is an empirical issue.)
But if you think that stock returns will be higher than GDP growth without either ratio increasing, then one of us is incapable of doing simple algebra, and I am going to guess that it’s not me.