Why the Dow Is Outperforming the Economy

If stocks get too far ahead of the real economy, they'll come tumbling back down.

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Traders work on the floor of The New York Stock Exchange on March 5, 2013, in New York City.

It's good for everybody that the Dow Jones Industrial Average has reached a new all-time high. Confidence will rise, retirement funds will swell and those with extra cash will spend more.

But the stock market only partially represents the U.S. economy, which still lags far behind the Dow, which set its prior closing record on Oct. 9, 2007. If you compare other economic indicators to the same date, there's still a lot of ground to recover.

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Total employment in October 2007, for instance, was about 138 million. Today it's about 135 million, so we're three million jobs short of where we were back then. The unemployment rate during the Dow's last peak was an enviable 4.7 percent. Today it's an uncomfortable 7.9 percent.

The overall economy has grown since late 2007, but at an extremely weak rate, on account of the brutal recession that ran from the end of 2007 to the middle of 2009. Real GDP, after accounting for inflation, is about 2.5 percent higher than it was in October 2007. On an annual basis, that's a pitiful growth rate of 0.5 percent, which is less than population growth.

Incomes are lower than they were five-and-a-half years ago. The latest data shows that median real household income, after inflation, fell from $54,489 in 2007 to $50,054 in 2011, a punishing 9 percent drop.

Americans are less wealthy, too. Total net worth in 2007 was $66 trillion. It's now about $65 trillion. Total net worth hit a low of $53.5 trillion in 2008, as the twin housing and stock market busts destroyed wealth. The Federal Reserve has deliberately pursued policies meant to reinflate financial assets, help the housing market recover, and rebuild lost wealth. We've now made up most of the ground lost over the last five years, if you count that as an accomplishment.

Washington is in worse shape than the private sector. The national debt was about $9 trillion at the end of 2007. It's now about $16.5 trillion, an 83 percent increase in just five years. The government's strained finances are now holding back the economy, with deeper cuts inevitable.

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The stock market has outperformed the economy because the big companies represented in stock indexes such as the Dow and the S&P 500 have recovered better than other sectors. As just about everybody in corporate America knows, big companies have relentlessly streamlined, laid off workers and adopted new technology wherever it will help shave costs. They've also been able to borrow money when many others are getting turned down for loans, taking advantage of record-low interest rates. One reason corporate profits have been strong amidst a still-weak economy is that many companies have been able to raise profit margins even as revenue has fallen.

Big U.S. companies also get about 40 percent of their sales from overseas these days, which means faster-growing economies, such as China's, help sustain business when other regions slump. That adds to profitability and helps push up stock prices.

Big companies have also been direct beneficiaries of the Fed's easy-money policies. The Fed doesn't really have the tools to raise employment directly—even though that is one of its mandates—so it tries to create favorable conditions for businesses so they'll hire more. So far, that policy has half worked; conditions are favorable for business but they haven't really started hiring yet.

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The stock market and the real economy exert a gravitation pull on each other, so that over time, they basically move in tandem. If the stock market has gotten too far ahead of the economy, it will fall back to a more realistic level. And if the economy if gathering more strength than indicators show, it will continue to push the stock market upward.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.