Historic run for stocks ends on high note

News Analysis

(MoneyWatch) The Dow Jones industrial average hit a record high this week, capping its historic run by gaining 68 points to close at 14,397. Until the latest run-up in stocks, that put the previous mark of 14,165, reached on Oct. 9, 2007, in the shade.

Let the good times roll? Not quite.

The significance of the market's nearly 120 percent rise from the depths of the financial crisis in March 2009 depends on your financial situation. In large part, that's because the stock market is not the economy and the economy is not the stock market.

The Economist notes, "It is tempting to attribute the strength of the Dow to optimism about the American economy. Tempting, but wrong. Studies have shown almost no correlation between GDP growth and equity returns.... this rally in the Dow has been accompanied by the weakest GDP growth of all the bull markets since the Second World War."

Rather, the stock market reflects the collective opinion of investors about the future ability of companies to make money. Clearly, the private sector is making money, often loads of it as profits reach record levels. From this perspective, the more than doubling of stocks since their housing bust lows is justified.

Corporate earnings have risen at an annualized rate of over 20 percent since the end of 2008, though much of the boost came early in the recovery. Still, companies were able to grow their earnings at a better than expected pace in the last quarter. The profit surge has allowed share prices to appreciate and for companies to increase their dividend payments to stockholders. According to industry estimates, S&P 500 companies are expected to pay out $300 billion in dividends this year.

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Other factors beyond strong corporate results are propelling the market. Europe is not currently on the brink of disaster, with the most pressing threat from the region's debt crisis having at least temporarily abated. China also appears to have avoided an economic "hard landing," while Japanese officials have started to address the country's 20-year economic stagnation.

But the biggest driver of the stock market's advance is the Federal Reserve, which has kept short-term interest rates at all-time lows since December 2008 and last September launched a third round of bond buying. The central banks has pledged to continue its easy money policies until the nation's unemployment rate drops to 6.5 percent.

While the Fed has said that low rates are intended to spur economic activity, they have another important aspect. Central bank-induced low rates can distort investment allocation decisions. Many investors, especially large institutions, are scanning the landscape and deciding that stocks are a better alternative to cash, bonds and commodities.

If you own stocks, these developments are welcome. But our financial lives and the economy are more than the value of our investment accounts. The economy has been growing only about 2 percent annually for the past few years, which is lower than the post World War II average.

Still, if growth remains weak, there is reason for hope. The housing market, which was at the epicenter of the financial crisis, has finally turned around. After peaking in 2006, housing is no longer be a headwind for the economy and instead will contribute to growth. Exactly how much is uncertain -- home prices remain down about 30 percent nationally, which has put a dent in the average American's balance sheet. But the real estate market does finally appear to be on the mend.

The Fed said this week that household net worth was up 9 percent from year-ago levels. Net worth peaked at $67.4 trillion in the third quarter of 2007, then collapsed in early 2009. By the end of 2012, it had risen to $66.1 trillion.

That means that despite the gains in the stock and housing market, Americans' total net worth is still $1.3 trillion below where it was in 2007.

With companies making money, the economy growing and the housing market back on its feet, why aren't people doing better? The answer lies in the nuance of the recovery. Dean Maki, chief United States economist at Barclays, told the New York Times that "as a percentage of national income, corporate profits stood at 14.2 percent in the third quarter of 2012, the largest share at any time since 1950, while the portion of income that went to employees was 61.7 percent, near its lowest point since 1966."

In other words, the fruits of the recovery have gone disproportionately to companies and their shareholders. In fact, workers have seen their incomes shrink since the beginning of the recovery. According to Sentier Research, median annual household income in January 2013 was $51,584, 4.5 percent lower than the median of $54,008 in June 2009, when the officially recovery began. That underlines the disconnect between the stock market and the plight of average Americans.