Photogrpah by Spencer Platt — Getty Images
By Stephen Gandel
August 25, 2015

If you are worried about the nearly 1,700 point drop in Dow Jones industrial average in the past week, you can take some comfort in what economists have long said about the economy and the market: They are only cousins, and not even close ones. Related, but only distantly.

That seemed evident a few years ago when the market hit a new all-time high despite the fact that the unemployment rate had barely dropped and the economy’s recovery still looked in doubt. And it seems like the case again today. The economy, pretty much everyone seems to agree, is strengthening. This time it’s the market that looks sick. An economist would tell you not to worry about it. Markets are random, and don’t say much about where the economy is headed.

That is particularly true these days when much of stock market trading is driven by algorithms. Some market observers said it appeared that adding fuel to the stock market rout were computer algorithms that are programmed to sell when volatility spikes as it did on Monday. As one Twitter humorist put it, it was indeed a tough day to be a computer on Wall Street.

But long-time observers of the stock market would tell you to be more worried. In reality, nearly every bear market, defined as a 20% drop in stock prices, has been followed by a recession. And while there looked like a disconnect between the market’s highs and the economic lull a few years ago, the market eventually turned out to be correct, if still a little too enthusiastic. The economy did recover, as the market predicted. The market’s timing may be off, but as fortune-teller for the economy, the market’s crystal ball has been better than much else.

And the recent drop in the market seems to be driven by economic fears, not the other way around. (Although once that cycle starts it’s hard to know what started it.) The worry is that a slowdown in China could slow the world economy, and have a much bigger negative effect than anticipated on the U.S.’s.

 

Of course, we’re not in a bear market yet. The market is only down 13% from its peak. Corrections, usually defined as stock prices having dropped 10% or more, are much less predictive than bear markets. Some have resulted in economic downturns. Others like in 1998 and 2011 came in the middle of economic expansions.

And while the market is down, the Dow is still at 15,871, which, yes, is nearly 1,700 points lower than it was a week ago, but it is also nearly 6,000 points higher than it was five years ago. So does that mean the economy is significantly better than it was five years ago? By just looking at the absolute level, or even percentage drops, it’s hard to say.

A better indicator perhaps of where the economy is likely headed is the market’s price-to-earnings ratio. These days the market’s P/E, as measured by an average of the past 10 years of profits, which is the way Nobel laureate economist Robert Shiller has said we should look at it, is 24, even after the market’s recent drop. That’s lower than where it was a few weeks ago, and certainly lower than the mid-40s it hit in the late 1990s and early 2000s, but it’s much higher than the 16 that P/E has averaged over the long term.

And it’s still a lot higher than the 13 the P/E plunged to in late 2008, when the market correctly predicted we were in for a nasty downturn and an anemic recovery.

A lot of things go into the market’s P/E ratio, and the future growth rate of the economy is only one of them. Investors also factor in interest rates, profit margins and tax policy, among others. But the outlook for future growth is a big one.

The economy, based on the last quarter of GDP, is growing at 2.3%. That is below the U.S. long-term average of around 4% for the past 100 or so years. And yet the market’s P/E, even after the past week’s drop, is above average, which suggests investors still think the economy is likely to continue to improve. That may prove to be too optimistic a forecast. And that’s something to be worried about. But that’s always a risk, whether the Dow has just dropped 1,700 points or not.

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