I suppose this may be a dumb question. Why is it that market indices have increasing trends in their values over time? Is it a mathematical artifact of log-normal distributions of individual share prices? Is it because poor performing companies get dumped and companies doing well replace them? Something else altogether?
Anybody got the straight dope?
inflation, with outliers based on the economic cycle.
I always thought that this was because the economy is expanding. There are periods of contraction, but they aren’t enough to wipe out the expansions that occur in between. Due to the continuous development of new technology and exploitation of additional resources, society as a whole has been getting gradually richer for centuries, and stock prices reflect this.
There is no guarantee that the price of an individual stock or of any combination of stocks as measured by one of the indexes will go up over time, as most folks who have invested in US-based stocks over the last three years can attest. (Our friends who invest in Japanese stocks are in worse shape - their main stock index recently hit a twenty-year low.)
Over the long haul, however, the trend is certainly upwards, and by a lot better than the inflation rate. Personally, I take it as an indication that capitalism works.
Here’s another angle… the population keeps going up, and the number of potential customers large firms in the S&P, etc can serve keeps going up as well. From this alone we could imagine that the indices will trend upward long-term, even without:
wooly’s perfectly reasonable “inflation, with outliers based on the economic cycle.” and jasonfinn’s technology.
It’s easy enough to separate “population growth vs. inflation vs. better technology” when looking at overall economic growth, but harder to do so for stock prices. Here are some statistics:
Population: 76 M in 1900, 285 M in 2003, CAGR = 1.3%
GDP deflator: 6 in 1900, 110.65 in 2003, CAGR (inflation) = 2.9%
Nominal GDP: $18.6 B in 1900, $10.4 T in 2003; CAGR = 6.3%
So we have real, per capita GDP growth (a.k.a. “improved standard of living”) of about 1.9% per year, on the average, since 1900. Obviously this is driven by improved technology and productivity.
Translating that growth into stock prices, and isolating the causes, is trickier. Stock prices at any given time reflect emotion, hopes and fears about the future, and factors unique to particular companies. Also, business is international, so stock prices reflect more than just American conditions. Nevertheless, for what it’s worth, here is growth in the two major stock indices:
DJIA: 68 in 1900, 8200 today, CAGR = 4.8%
S&P 500: 6.1 in 1900, 876 today, CAGR = 4.9%
Growth in the stock indices, then, has actually lagged economic growth. I suppose this is because the economy is less concentrated today, and the 30 companies of the DJIA or the 500 of the S&P represent less of the economy as a whole.
Keep in mind that these these indexes are not adjusted to reflect the dividends that they yield. The S&P 500 currently yields about 2%, so you’d still get about a 2% return even if the index stayed fixed at 876.
The actual inflation-adjusted CAGR has been around 6.5% over the past two centuries.
See Dr. William Bernstein’s article The Two-Percent Dilution.
yep, and don’t forget that the losers get dropped out of the index.