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What does the Dow's record say about the economy?

(MoneyWatch) The Dow Jones Industrial average set another nominal record Wednesday, closing at 14,296, a gain of 42. What does the increase in the Dow over the last few years and the increase in stock prices stocks more generally tell us about the future of the economy?

In inflation-adjusted terms, this is not actually a record. Stock prices increase with the rate of inflation, and in order to reach an inflation adjusted high the Dow would need to gain approximately another 10 percent, somewhere around 1,500 points (but as many people have noted, if dividends are accounted for, the Dow has, in fact, achieved its pre-recession peak).

But record or not, the Dow has been on an upward trend since 2009, and the steady increase in prices reflects both the recovery that began in 2009 and the monetary policies the Fed has pursued, particularly its quantitative easing policies.

Under those policies, the Fed has purchased large volumes of financial assets, creating an increase in demand that has helped to drive up stock and bond prices. In addition, monetary policy has helped to boost the economy, in part through greater spending induced by this "wealth effect" from higher asset prices, and this has a feedback effect that further increases asset prices.

How much of the increase in the Dow and in stock prices more generally is due to the increased demand for assets from the Fed, and how much is due to optimism that the recovery will continue? A recent speech by Federal Reserve governor Jeremy Stein made it clear that the Fed is worried about emerging price bubbles in some financial markets. The worries aren't at the point where the Fed believes it needs to take any action, but it is keeping a close eye on these markets, an indication that it believes that its actions have had a significant impact on asset values. Nevertheless, the main driver of the run-up in the Dow since 2009 is the improving economy.

Most analysts expect the recovery to continue, but that prediction has very little to do with asset price movements. Using the stock market to predict the future of the economy is risky. For example, the previous peak in the Dow was in October 2007, just two months before the onset of the recession. That peak certainly didn't indicate that the economy was on solid footing. More generally, the relationship between the stock market and the economy is not very reliable and stock market values only explain a small proportion of the total movement in variables like GDP and employment. Thus, while it's very likely that the recovery will continue at its slow pace, that prediction has little to do with recent movements in stock prices.

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