Blog - Investing Notes

January 2, 2006 - Update: Does Productivity Drive Stock Prices?

Workforce productivity changes should jointly affect corporate earnings and inflation, the two key inputs to our Real Earnings Yield Model. Other things being equal, more productive workers allow companies to increase profit margin (and/or worker compensation) without raising prices. Do quarterly announcements of productivity changes therefore move the stock market? What is the long-term trend in U.S. workforce productivity? Using quarter-over-quarter annualized changes in non-farm labor productivity from the Bureau of Labor Statistics and S&P 500 index data since 1950, we find that:

The following scatter plot depicts the relationship between the quarterly change in the S&P 500 index and the annualized change in non-farm productivity for the same quarter since 1950. There is no visually obvious connection. The Pearson correlation between these two series is only 9%, and the slope of a best-fit line is 0.21. These results indicate only a very weak tendency for the stock market to react to productivity changes. The connection is even weaker when we relate productivity changes to future S&P 500 behavior. The bottom line is that investors/traders should not give much weight to quarterly productivity changes as trading signals.

We note, however, that the average change in productivity for the ten best quarters for the S&P 500 index during 1950-2005 is 4.3%, well above the overall average of 2.3%. For the ten worst quarters for the stock market, the average productivity change is only 1.8%. Also, when the change in productivity is above average during 1950-2005, the average quarterly gain in the S&P 500 index is 3.0%, above its overall average of 2.2%. When the change in productivity is below average, the stock market gains only 1.6% per quarter on average. These statistics support a generally positive relationship between productivity and the stock market.

What about the bigger picture? What is the long-term productivity trend, which could be a critical indicator of the long-term trends in corporate profitability and the inflation rate? Jeremy Greenwood in his 1997 article on "The Third Industrial Revolution- Technology, Productivity, and Income Inequality" sets the stage. He identifies 1974 as the beginning of the information technology-driven third industrial revolution, with technology prices plunging and productivity initially falling during an adoption/incubation period of about 20 years. Then productivity takes off.

The next chart shows quarter-over-quarter annualized changes in non-farm labor productivity since 1950, which is quite volatile. To dampen the effects of the major U.S. political cycle and thereby distill the big picture, we add a one-year lagging average since 1951. Finally, we add the annualized inflation rate at the end of each quarter (calculated using Consumer Price Index data from the Bureau of Labor Statistics) so that we can compare productivity change and inflation. It appears that inflation and productivity are related inversely.

Can we describe more explicitly a connection between the long-term productivity trend and the inflation rate? The next chart depicts the relationship based on quarterly data since 1951. The Pearson correlation for these two series is a moderately inverse -43% (inflation tends to fall when productivity rises). The slope of a best-fit line is -0.73, indicating that productivity changes have a fairly large impact on the inflation rate. The currently relatively strong productivity growth rate should therefore be significantly deflationary, providing a secular tailwind to the stock market per our Real Earnings Yield Model.

The average change in productivity for the ten highest inflation rates during 1951-2005 is -0.4%, well below the overall average of 2.2%. For the ten lowest inflation rates, the average productivity change is 3.5%, well above average. Also, when the change in productivity is above average during 1950-2005, the average inflation rate is 3.1%, below its overall average of 3.9%. When the change in productivity is below average, the inflation rate averages 4.8%. These statistics confirm that high productivity levels tend to suppress inflation.

In summary, quarterly productivity changes are not useful as trading signals, but the long-term productivity trend affects the stock market because it suppresses inflation, and probably boosts corporate earnings. The current relatively high level of productivity growth is good for the stock market.

See Blog Synthesis: The Economy and the Stock Market for other research on relationships between macroeconomic indicators and stock market behavior.