Investing in the stock market makes sense, part 1

I want to talk to everyone about a general theory of why investing in the stock market makes sense. The usual arguments are that stocks have outperformed every asset class since the onset of the Great Depression in 1929. But that’s not a logical reason. That is simply evidence of the underlying logic of why stocks usually make sense.

The Bedrock
Economy-wide economic growth is measured by Gross Domestic Product (GDP). If measured well, GDP should be the sum total of all the economic growth of governments, businesses and individuals in the economy. Why might GDP grow? The components of GDP growth include: population growth, innovation and inflation. Let’s take each of these in turn.

Population Growth
GDP ought to grow in lock step with the growth of the population. Because there are more mouths to feed, there are more schools to build, more clothes to sew, more computers to make, etc. A mitigating factor is whether or not new members of society consume goods and services in the same depth and breadth as previous consumers. If the new people don’t buy as much stuff then GDP will still grow, but at a slower pace than the population. Does this make sense?

So a sign of a healthy economy is one that grows faster than the population grows. When that occurs it is because there is growth in either of our last two categories.

Innovation
When people discover new ways of doing things that save resources, yet generate the same economic result, there is economic growth. Additionally, invention leads to whole new industries, new products, new services and new conveniences. The essence of innovation is the literal creation of that which did not exist before, or of saving resources. One of the important and traditional measures of this kind of economic growth is productivity. However, productivity does not capture the full wallop of true innovation. For example, the Internet lowered the cost of information by many orders of magnitude and the economic benefits of super cheap information and distribution of electronic goods is still not fully tapped.

Inflation
Inflation is one of those terms whose meaning economists can never agree upon. I tend to think of inflation as money growing faster than the economy. Too much money means that businesses start raising their prices to keep pace with the excess money. Inflation is accounted for by economists, though imperfectly. So when we look at GDP we want to always exclude the effects of inflation. This is a fairly easy calculation to make, and many financial news websites do it for you.

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Now with those definitions out of the way we can see that if the percentage inflation growth and the percentage population growth are excluded from GDP we get a rough estimate of innovation. Ultimately it is innovation that drives economic growth. In the U.S. economy GDP, in expansionary periods, grows at about 5% annually. When inflation adjusted, the rate of growth is around 3%. The U.S. population is growing at about 2%. So that means that very roughly, innovation grows around 1% per year in economic expansion times. Why is this important, and how does this contribute to the argument for investing in stocks?

This is important because GDP is the bedrock underneath the stock market. Because publicly traded companies represent a goodly portion of the business that is conducted in the United States and the globe, then stocks ought to at the bare minimum keep pace with unadjusted GDP growth. Businesses, in the aggregate, address each GDP component. When the population grows businesses have new customers to sell to. Thus, businesses on average should keep pace with population growth. When inflation effects the economy businesses ought to capture those effects, too by raising their prices. Lastly, businesses should constantly be striving to innovate and thus they should capture these benefits also.

So our first axiom for why investing in the stock market make sense is:

Axiom 1: In the aggregate, publicly traded businesses should always keep pace with GDP.

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Part 2 will be posted tomorrow…

Jason