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The Stock Market and Arithmetic

by Arnold Kling

February 14, 1997

There are a million ways to look at the stock market. I was trained to use accounting and arithmetic.

Here are some facts about corporate profits, national income, and stock prices.

National Income, Corporate Profits and Stock Prices, Total Increase

Time PeriodNational IncomeCorporate ProfitsDow Jones Industrial Average
1959-1977394 %333 %142 %
1977-1996, Q3384 %395 %636 %
1959-1996, Q31511 %1317 %899 %

(Source: The Economic Report of the President, 1997. Data available through third quarter (Q3) 1996)

Some observations:

Looking at the future, it is much easier to predict national income and corporate profits than it is to predict stock prices. National income is likely to grow at about 5.5 percent, give or take a couple of percentage points. This is based on an assumption that inflation will be about 3 percent and real growth will be about 2.5 percent, for a total of 5.5 percent.

Corporate profits probably will grow at about the same rate as national income. This is not what we have seen in the past four years. From 1992 to 1995, profits grew at a 13.5 percent annual rate, compared with 5.5 percent for national income. This boosted the share of profits in national income from 8.1 percent to 10.1 percent. 1996 data were not yet complete as this was written, but it is very likely that the share of corporate profits took another jump of at least 1/2 of one percent.

The bottom line is that the most probable outlook for corporate profits it that they are likely to grow at "only" 5-6 percent in the next several years. This is very nearly a matter of arithmetic. Suppose instead that for three more years profits grow13 percent and national income grows 5.5 percent. This would bring the profit share up above 13 percent, with the shares of workers and small businesses falling. This is possible, but not nearly as likely as a scenario in which income shares remain stable.

What does this arithmetic mean for stock prices? In the short run, it probably means nothing.

Many observers believe that stocks will continue to go up at double-digit rates. They may be correct. However, the way the arithmetic looks to me, profits are not going to rise enough to validate such increases.


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