Monday, May 16, 2005

Summer Stroll #4 -- Why Do Stocks Go UP?

Did you ever wonder why stocks have risen over almost all of recorded history? You realize of course, if you can answer that question you will have the basis to answer the more important question -- where are stocks going from here? It turns out the answer is really quite simple. Stocks in the United States have risen because earnings and dividends have grown, and earnings and dividends have grown because the economy has grown. As you will see, the numbers are so similar we often wonder why we don't see more written about it in the popular media. As we said in our last edition, over the last 45 years, earnings and dividends have grown at 6.7% and 5.4%, respectively. Since 1960, Nominal Gross Domestic Product ( The measure of all goods and services produced in the US) has grown at 7.3% per annum. Nominal GDP is not a term you hear very often, but it is simply GDP not adjusted for inflation. Think about it. Stock prices are not adjusted for inflation, so to compare apples to apples we need the gross figures for economic growth and not the net figures. The GDP growth that we hear most often is in the range of 3%-4%, but that is after subtracting inflation. The US economy has actually grown at an annual rate of 7.3% for the last 45 years. Inflation, during this time, has averaged about 4.3%, leaving net GDP growth of about 3% on average for the period. What is the bottom line on all this data? As it relates to the Dow Jones Industrial Average, we believe it means that stock prices will continue to grow in the range of 6.5%-7%. Adding in the current dividend yield of 2.4% gives us a projected total rate of return over the next few years of 8.9%-9.4%. With 10 year Treasury bonds at 4.2%, stocks look awfully cheap to us.