Stock prices are notoriously volatile, even when measured by a broad index like the S&P Composite. You might think that the S&P Composite is sensitive to broad changes in economic activity, as measured by GDP, for instance. But, as it turns out the S&P Composite, despite its volatility, is a leading indicator of GDP.
I begin with this graph:
Sources: The index of real GDP is derived from estimates of real GDP available at MeasuringWorth.com. The index of the value of the S&P Composite index is derived from Robert Shiller’s data set at http://www.econ.yale.edu/~shiller/data/ie_data.xls.
It is not apparent in the preceding graph, but GDP lags the S&P Composite. The correlation between the percentage change in real GDP and the percentage change in the real S&P composite in the same year is 0.43 (r-squared = .19). The correlation between the change in GDP and the change in the S&P a year earlier is 0.36 (r-squared = 0.13). That correlation is considerably stronger than the correlation between the change in GDP and the change in the S&P a year later (-0.10; r-squared = 0.01), which suggests that the S&P index is a leading indicator of GDP, not the the other way around.
Notes: Both correlations are significant at the 0.1-percent level. The years 1941-1946 are omitted because of the abrupt and largely artificial changes in GDP that arose when the U.S. government commandeered the economy and diverted vast resources to the war effort during World War II.
It seems unnecessary to point out that the correlations are not strong enough to derive precise predictions of GDP from changes in the S&P. However, one could do worse than rely on simple correlations, given the poor track record of complex macroeconomic models (e.g., see this).
It is unsurprising that the stock market has been heading downward since 2000 (despite occasional rallies). Investors know that economic growth is sagging under the pressure of government spending and regulation.
The Price of Government
The Price of Government Redux
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Rahn Curve at Work
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Stocks for the Long Run?
Estimating the Rahn Curve: A Sequel
Bonds for the Long Run?
The Real Multiplier (II)
Lay My (Regulatory) Burden Down
Economic Growth Since World War II
More Evidence for the Rahn Curve
Progressive Taxation Is Alive and Well in the U.S. of A.
The Economy Slogs Along
The Obama Effect: Disguised Unemployment