The Grand Casino

I realize that for a lot of readers, the stock markets are just a surreal casino, and that the many posts I have done on them are widely ignored. You’ll get no argument from me that the stock market does not represent real investment or the real health of an economy. However, I think that financial news is some of the only reliable news that we get, and it makes sense to parse it carefully to see what implications it has for the economy and the political system.

So: US markets were down a lot less than one might have thought from the way that Asia and Europe were shaping up. Once again, DAX (Germany) and CAC (France) were down, while FTSE was up, and Asia looks set to go green. It’s early, but US markets look set to open green. These data tell me that the belief is that the hot potato from the financial crisis of 2008 is in the hands of Europe.

It’s worthwhile looking at a long-term perspective. The chart below is the S&P, corrected for inflation, since 1950. Since there aren’t daily corrections for inflation, I’ve used the close of the first day of the year to represent the year. That can produce some oddities, such as the fact that the market low in March 2009, was at 666. [Note added: Robert Schiller has produced a much nicer graph here, along with the data, including inflation corrections by quarter.]

The key figure that comes out of this is the slope of the least squares line, which represents the long-term growth rate. I came up with 2.7%, whereas the Schiller data say 2.6%; let’s use the latter. That means that if you own stock, and don’t re-invest the dividends, you can expect it to double in real value over 27 years. Since dividends have been roughly 2.5% on top of the growth rate (they were over 5% in the early 50s and are around 2% now), if you were not dependent on income and could reinvest dividends, you could double your money in about 14 years. It also means that if you wanted to have a middle class lifestyle, spending about $50,000 per year, you had to have a million dollars in the market–plus reserves for those bad years when you were spending out of principal– just to not lose value. Being a millionaire nowadays barely makes one independently wealthy, and that’s not even reckoning health insurance costs.

A key figure that comes out of the graph is what constitutes fair value, assuming that the world goes on as it has since 1950. This analysis suggests that that is at 1240. Since the S&P closed at 1165, it’s approximately fairly valued. According to the 10 year P/E developed by Robert Schiller, the S&P is at 20 price/earnings, very richly valued. It would not enter value territory before going below ca. 1090, and would not be into real value territory for another several hundred points.

The stock market data is telling us that the US economy (as opposed to the people who work in it) is in much better shape than one might think.