The belief that stock markets must crash because they outpace GDP growth is a common misconception. It’s true that historically, U.S. GDP has grown at an average of about 3%, while stock returns have averaged around 10%. This discrepancy leads some to fear that stocks are overvalued and due for a crash. However, this view misunderstands the nature of both GDP and stock market returns.
GDP: A Measure of Output, Not Economic Health
GDP, or Gross Domestic Product, measures a country’s economic output. It’s an imperfect metric, often revised and based on surveys and assumptions. Importantly, GDP doesn’t reflect a nation’s wealth or assets. It’s a flow measure, not a stock measure. For instance, even if the U.S. GDP growth was zero for a year, the country would still have produced a significant amount of output.
Moreover, GDP doesn’t perfectly mirror economic health. Its calculation includes private consumption, gross investment, government spending, and net exports. The U.S. has been a net importer for decades, which negatively impacts GDP but isn’t necessarily a sign of poor economic health. In fact, net importers like the U.S. and UK often have higher growth rates than net exporters.
Government Spending and Economic Efficiency
Reduced government spending can detract from GDP but isn’t inherently negative. In fact, excessive government spending can crowd out more efficient private sector spending. The private sector typically uses capital more effectively, leading to better economic outcomes. In contrast, government spending, even if poorly executed, doesn’t face the same market pressures as private spending.
Stocks vs. GDP: Different Entities
Stocks represent ownership in companies and their future earnings, not a slice of the current or future GDP. Stock prices are influenced by corporate earnings, which are a result of revenues minus costs. These earnings are not directly included in GDP calculations. Therefore, stock returns and GDP growth rates are not directly linked and shouldn’t be expected to match.
The Misleading Nature of Linear Scales
When comparing stock returns to GDP growth, it’s important to consider the scale used in graphs. Linear scales can make recent stock market returns appear unsustainable, especially when compared to historical data. However, a logarithmic scale, which accounts for the compounding nature of stock returns, provides a more accurate representation. On a logarithmic scale, proportional changes are consistent, making it a better tool for understanding long-term market trends.
Conclusion: Innovation Drives Stock Growth
Ultimately, stock market growth is driven by the continuous advancement of innovations, leading to increased earnings over time. This growth is not directly tied to GDP but is a result of the dynamic nature of businesses and economies. Therefore, the fear that stocks must crash because they outpace GDP growth is based on a misunderstanding of what these metrics represent and how they interact.