Those of you July 18, 1997
Supply-Side Summer School Economics Lesson #5
Memo To: Summer-School students
From: Jude Wanniski
Re: Dow Jones Industrial Average at 8000
I was planning a discussion of the intersection of monetary policy and fiscal policy, but Michael Zilkowski of Saskatoon, Sask., has his hand up to ask what he says may be a “stupid question.” He asks what the number 8000 represents, in reporting it as the Dow Jones Industrial Average. With the DJIA having broken through the 8000 plateau this week, it is an appropriate time to deal with Michael’s question. Most people who work on Wall Street, by the way, spend their entire careers working around the DJIA and never really know what it is about, except that it goes up and down, so we thank Michael for posing a fundamental question.
The DJIA is a standard of measure, a concept rather than a real thing. It is one way of thinking about the value of the nation's capital stock, which is real. The nation’s capital stock is comprised of all the factors of production available to produce useful goods and services -- physical and human capital in combination. Think of this capital stock as a pyramid of machinery, or a cornucopia that churns out things that people need and want to make their lives better. It is a pyramid that has been saved and invested out of past production, that part of production which was not consumed and has not since deteriorated. When does the value of this capital stock rise? When the many elements that are part of it are seen coming together in a way that increases the likelihood that the capital stock will be more effective in the future in producing a stream of goods and services. In other words, the value of the stock is not what it can produce today, but what it will be able to produce as far into the future as the eye can see, discounted to present value. A discount to present value is a way of thinking of all the goods the machine will produce in the future, minus all the costs of running the machine, with profit being what remains. Each “machine” can be represented by a share of stock that is valued according to the future profits it can produce. If a share of stock falls to zero, it means the value of its underlying assets are incapable of producing goods and services that will be valued at more than their cost of production.
A value of 8000 is not necessarily better than a value of 7000. You have to have more information before determining that the higher number is better. I put it that way to remind you that the number itself is a concept, not something real. It is an index of 30 other concepts -- the 30 stocks that comprise the Dow Jones Industrials. Each of the 30 represents a dollar price of a share of carefully selected industrial corporation -- 30 corporations of different industrial sectors. There is also a weight assigned to the share to reflect stock splits and other factors. The portfolio attempts to be as representative of the mature capital stock as possible. From time to time over the past century, the keepers of the index throw out corporations that are no longer representative of the dynamics of the overall economy. Until recently, Woolworth for most of the century represented the retail consumer sector. It was recently dropped from the portfolio, replaced by WalMart, suitably weighted to reflect a precise switch in values at the moment of exchange. No longer representative, it was no coincidence Woolworth this week closed the last of its outlets. Think of the DJIA contingent as the very top of the pyramid. There are millions of corporations and partnerships in the pyramid, almost all of them privately held. There are perhaps 10,000 corporations publicly traded on stock exchanges large and small. It is because the Dow stocks are so carefully selected that the index of only 30 continues to be the most important and the most informative. Financial reports on radio and TV will report the S&P 500 index as a near competitor, but the man on the street wants to know the DJIA. The general news reports -- such as those broadcast hourly by the CBS radio network -- always report the Dow, the price of gold, and the 30-year Treasury bond. More recently they have been reporting the NASDAQ index, as a broad picture of what is going on down in the financial pyramid.
The price of gold is a key piece of information for the ordinary citizen who is trying to get a sense of the economic environment. If the DJIA is 7000 and the price of gold is $300 an ounce, and it then rises to 8000 while the price of gold rises to $350 an ounce, the value of the Dow stocks will have declined in terms of gold. In the former case, the 7000 Dow is worth 23.2 ounces of gold. In the latter case, the 8000 Dow is worth only 22.8 ounces. This makes the current surge of the Average to 8000 all the more impressive, because it has been accompanied by a decline in the gold price. At a 6000 Dow and gold at $383, the Dow was worth 15.7 ounces of gold. At 8000 and $318, the Dow is worth 25.2 ounces. This is an incredible climb in a mere 9 months -- a 60.5% increase in the Dow’s value.
This does not quite mean the Dow is predicting a 60.5% increase in national production. It means it sees, looking as far as it can, a 60.5% increase in the quality of price and earnings of the current capital stock -- at least insofar as the index is representative of the pyramid as a whole. The number can’t be taken as gospel in this regard, because it does represent only 30 selected companies. This is why the market has found need for dozens of other indices that reflect different tendencies within the pyramid. Theoretically, earnings can rise in value even if Gross National Product declines. This is because GNP includes the production of all goods and services associated with the inefficiency of our tax system and unpredictability of our money. If in an instant these inefficiencies were removed, millions of people and associated costs would be lifted from the capital stock. GNP would decline, but the value of the capital stock would rise. If we think back to January 1966, when the Dow hit 1000 on interday trading, when gold was at $35, the Dow was worth more than it is worth today, 28.6 ounces of gold. This is why I’ve not been at all surprised at the surges we have seen in the last several years, knowing that on this scale of measurement, the Dow has to be at 10000 before it is seeing a standard of living coming out of the American cornucopia that it saw back in 1966.
As you see, Michael’s question was a good one, fundamental to our understanding of the way the market works. It is most appropriate to have it discussed in our Supply-Side university. In the demand-side universities, the question is rarely dealt with adequately. In the 14th edition of Economics, by Samuelson and Nordhaus, there is a mention of the DJIA on page 519: “Trends in the stock market are tracked using stock-price indices, which are weighted averages of the prices of a basket of company stocks. Commonly followed averages include the Dow-Jones Industrial Average (‘DJIA’) of 30 large companies, and Standard and Poor’s index of 500 companies (‘S&P 500'), which is a weighted average of the stock prices of the largest American corporations.”
In the same section, “Appendix 28,” on “Stock Market Fluctuations,” the authors discuss the stock market “Great Crash” of 1929 in the following way:
A study of stock exchanges and financial markets relies upon both economic analysis and a careful reading of the lessons of history. One traumatic event has cast a shadow over stock markets for decades -- the 1929 panic and crash. This event ushered in the long and painful Great Depression of the 1930s.
The “roaring twenties” saw a fabulous stock market boom, when everyone bought and sold stocks. Most purchases in this wild bull market (one with rising prices) were on margin. This means a buyer of $10,000 worth of stocks put up only part of the price in cash and borrowed the difference, pledging the newly bought stocks as collateral for the purchase. What did it matter that you had to pay the broker 6, 10, or 15 percent per year on the borrowings when, in one day, Auburn Motors or Bethlehem Steel might jump 10 percent in value!
A speculative mania fulfills its own promises. If people buy because they think stocks will rise, their act of buying sends up the price of stocks. This causes people to buy even more and sends the dizzy dance off on another round. But, unlike people who play cards or dice, no one apparently loses what the winners gain. Of course, the prizes are all on paper and would disappear if everyone tried to cash them in. But why should anyone want to sell such lucrative securities?
The great stock market boom of the 1920s was a classic speculative bubble. Prices rose because of hopes and dreams, not because the profits and dividends of companies were soaring. The crash came in “black October” of 1929. Everyone was caught, the big-league professionals as well as the piddling amateurs -- Andrew Mellon, John D. Rockefeller, the engineer-turned-President in the White House, and Yale’s great economics professor Irving Fisher.
When the bottom fell out of the market in 1929, investors, big and small, who bought on margin could not put up funds to cover their holdings and the market fell still further. The bull market turned into a bear (or declining) market. By the trough of the Depression in 1933, the market had lost 85 percent of its 1929 value.
This is all slimy stuff, heavily ideological, designed to fix in the minds of students that markets are irrational, which of course means that governments must manage markets and economies. It is also designed to pin all the blame for the Depression on the Republicans and none of Franklin Roosevelt, a hero to the authors of the textbook. Roosevelt, of course, was inaugurated in 1933. The trough of the stock market, on the other hand, was in July of 1932, when Roosevelt accepted the Democratic nomination and signaled a policy of free trade in his inaugural address. At that point, the DJIA was at 41, down 89% from its high of 381, on September 2, 1929. As I demonstrated in my 1978 book, The Way the World Works, the market crash of 1929 was due to the Smoot-Hawley Tariff Act of 1930, which was the first of several blows that drove the economy into the Great Depression. It is inconvenient for Samuelson and Nordhaus to recognize my thesis, as opposed to their speculative bubble, because Smoot-Hawley was supported by Democrats and Republicans, and especially by organized labor. The Great Depression lasted until World War II, with Roosevelt doing considerable damage with increases in income tax and capital gains tax throughout the 1930s. The only way the accounts can show a trough in 1933 is to ignore Roosevelt’s increase in the price of gold in 1934, to $35 per ounce, from $20.67. The DJIA rose from 41 to 100 in 1933, but if your divide 41 by 20.67 you get about 2 ounces buying to the Dow. Dividing 100 by 35, you have a Dow equating with 2.85 ounces. The Dow then did begin a climb to 200 in 1937, but Roosevelt then pushed through an increase in the income tax and capital gains tax and the Dow fell back to 100. It recovered 75% of its gains in 1938 when Congress rolled back the capital gains tax over FDR’s objection. Industrial production hit a nominal low of 55.6 in 1933, hence “the trough of the Depression.” It fell from more than 90 in 1937 to 84.7 in 1938. In ounces of gold, this meant production was 2.69 in 1933 and at 2.42 in 1938. In terms of unemployment, 1933 was clearly the “trough of Depression,” with an average of 24.9%. It fell to 14.3% in 1937, but jumped back to 19% in 1938, following the hike in tax rates.
Thank you Michael Z for your “stupid” question. Let’s have more of them.