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Finding the Missing Link Between Stocks and GDP

What do our eyes tell us? The big dip between the mid-1960s and late-1970s coincides with rising inflation, while the succeeding move higher corresponded with disinflation. As we can see below, this is a pretty good start, but it has gaping holes of its own. Sharp reductions in the Consumer Price Index in 1975-1976 and the general disinflation of the 1980s didn't pull stocks higher as we might expect. Moreover, the equity bubble of the 1990s and its subsequent bursting all took place within a narrow range of measured inflation. Let's keep the annualized CPI changes off to one side as one explanatory variable.

Usual Suspect Number One: Inflation
Source: Bloomberg

Qs You Can Use

Once inflation is parsed out of the model, other market-derived variables such as long- and short-term interest rates, the shape of the yield curve and the exchange value of the dollar have to be excluded as well. All of these measures are too related to each other to be included simultaneously. Even worse, we don't have long histories of free-market prices for energy or currency-exchange rates.

Stock prices measure, or should measure, the expected return on capital. When prices are high and expected returns are low, we should expect new investment to fall and the return on existing-capital stock to rise. The late Nobel laureate James Tobin created a measure now referred to as Tobin's Q, which is the ratio of the market value of capital to its replacement cost. A Q-statistic greater than 1.0 indicates stock prices are overvalued relative to the replacement cost of their underlying assets, and that leads to a surge in new stock issuance. This wave of new investment capital drives down returns and leads to both overcapacity and lower stock prices. If any of this sounds familiar, it should.
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