We use several strategies to add value to your portfolio. We select high-quality funds in areas that are currently out of favor, we increase stock allocations when stocks fall out of favor, and we cut back on stocks when they return to popularity. This article addresses the last strategy.

Economic indicators continue to fuel concerns about a potential economic slowdown. Earlier this week, economists revised first quarter GDP figures:

<i>"Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 0.6 percent in the first quarter of 2007, according to preliminary estimates released by the Bureau of Economic Analysis."</i>

This revelation represented a downgrade from previous estimates, <i>"in the advance estimates, the increase in real GDP was 1.3 Percent."</i>

This downturn could get scary if it morphs into a recession, but that’s not why we’re bringing up the GDP issue.

There's a strong correlation between the GDP and the stock market. As the economy grows, U.S. corporations will generally earn more money.

Economists prefer to talk in "real"{ terms by using figures that have been adjusted for inflation. For stock investors, nominal terms are actually more interesting. 

According to the BEA, <i>"current-dollar GDP…increased 4.7 percent."</i> In other words, the economy grew quite a bit larger (in dollars) between the end of last year and the close of the first quarter this year, but those dollars are a little less valuable.

When you examine historical stock market returns, you're dealing with nominal figures. If the Dow were up 10% last year, it really rose only 7% or so in "real" terms once inflation is calculated into the mix. 

In the years between 1929 (after the initial market crash) and 2007, the Dow rose from around 250 to 12,500 – a 5.2% annualized return (not including dividends). The economy, in non-inflation-adjusted dollars, went from about $100 billion to $13,500 billion – a 6.5% annualized return.

The Dow has returned a dividend yield of about 4% for the last 70 years. Add that to your price gains and you’re looking at around 10% a year on average.

Today, the dividend yield on the Dow is around 2%. The "nominal" GDP is growing at a rate of approximately 5%. If the economy continues to grow at that rate for the next ten years, you can expect a total stock return of nearly 7% over the same time period. Obviously, we could see more if the economy heats up, or less if it slows.

But even the 10% historical return hides the real year-to-year action in stocks. While the GDP is considered a pretty stable "index", stocks are anything but. The market tends to swing from one extreme of irrational exuberance (to use a Fed chairman’s lingo) to the other extreme of irrational fear.

In the 1990's, the economy was undeniably hot, but the stock market was on fire. In the early 2000's, the economy was soft, and the stock market sank 50%. The recent near-doubling of stocks from their 2002 lows definitely changed investors' moods from pessimistic to optimistic, but the economy certainly didn’t double. 

While we prefer to watch fund investor flows, (what better measure of investor pessimism could there be than fund investors selling their fund shares?) one simple way to judge the market's mood is to observe the relationship between the Dow and the GDP. For some odd reason, the numerical value for the Dow is usually in the ballpark of the nominal size of the economy in billions. We say this is odd because the Dow is comprised of a somewhat arbitrary grouping of 30 large companies, while the index is set by the stock prices – not even the market cap. 

In times of irrational exuberance about the economy and stock market, the Dow tends to trade at a premium to the GDP. Back in 1929, the Dow peaked at around 381, and the GDP was around $100 billion. The Dow traded at a 260% premium to the GDP. We all know what happened next. The GDP crashed about 50% over the next three years, while the Dow fell closer to 90%. By 1932, the Dow was closing at 60 and the GDP at 58 – near parity. Order was restored to valuations. Painfully.

The Dow really didn’t start delivering solid, double-digit, annualized returns until about 1941 – when it was trading at a 12% discount to the GDP. That discount continued for more than a decade. Stocks gave us big returns. 

People didn’t catch on to the stock market money machine until the mid 50's when the Dow began trading at a premium to the GDP once again. Investor excitement pushed stock prices higher, into what would become the "go-go" years. By 1965, it was trading at a 35% premium to the GDP. Then returns faltered, and investors threw in the towel on stocks altogether. By 1981, the Dow was only at 875, but the GDP was at $3,131. The Dow was now trading at an amazing 72% discount to the GDP. This marked the beginning of one of the strongest markets in history, one that didn’t really end until 2000.

The Dow traded at a discount to the GDP from 1969 to 1998. By 1999, the Dow was trading at a 24% premium.

By the bottom of the market in 2002, the Dow hovered around 7,200 while the GDP was at nearly 10,500 – over a 30% discount. The reduction of that discount triggered the large gains that we've enjoyed in recent years.

So what does this tell us? The Dow recently achieved parity with the GDP. While this is certainly not as dangerous a situation as existed in 1929 or even 1999, it does indicate that the upside is going to be limited. Sure, we could see another 25% in premium to GDP inflation, as we observed from 1998 to 1999, but 1998 was an excellent time to cut back on stock allocations, which is exactly what we are going to do in our portfolios later this month.