DAY TO DAY, STOCK prices are driven by the latest news—government data, corporate announcements, political developments, you name it—which is why it’s so hard to forecast short-term performance. But in theory, over the long term, the key driver of stock returns should be economic growth.
That appears to have been (sort of) the case over the 50 years through year-end 2020. During that stretch, nominal U.S. economic growth (which includes inflation) averaged 6.1% a year, per-share profits for the companies in the S&P 500-stock index rose 5.9% and the S&P 500-index climbed 7.7%. Meanwhile, annual inflation ran at 3.8%.
In other words, the growing economy drove up corporate profits and that, in turn, propelled share prices higher. On top of that, investors also collected dividends. Fifty years ago, the S&P 500 companies collectively generated a yield of 3.5%. As of year-end 2020, the yield was 1.6%. The stock market’s share price-to-earnings multiple was 17.6 at the beginning of the 50 years and the P/E was 40.7 at the end. (The latter number—very high by historical standards—reflects the collapse in corporate earnings caused by the pandemic.) That rising P/E ratio explains why share prices climbed 1.8 percentage point a year faster than corporations’ per-share earnings.
Problem is, the past 50 years could be a little misleading, as you’ll learn in the next section. Yes, there may be a long-run relationship between economic growth and stock returns. But stock investors may not reap the full benefits of economic growth.
Moreover, economic growth and stock returns are often barely related in the short term. Why? Investors don’t care whether the economy is booming or suffering right now. Instead, they’re focused on what might happen next year or the year after that. This is the reason savvy investors will often buy stocks in the midst of a recession, anticipating that the economy will soon recover.
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