Financial Services Bubble 1995-2008. R.I.P.

It is often thought that stock market values should be expected to track along more or less in line with nominal GDP. If that had happened to the DJI 30 from March 1995, when it first passed 4000, it would be a little under 8000 now. Well, that's just about where it is, but only after plunging from over 14,000 in October 2007.

What the rise in the DJI 30 did track was the money supply, which increased 205% from 1995 to 2008 while nominal GDP was increasing only 95%. All of the extra money seems to have gone into inflating investable asset prices because there was very low inflation in the consumer price index during this period. Now the money supply and asset values seem to be shrinking, rapidly, together.

Not surprisingly, growth in earnings of companies in the financial sector was vastly greater than the earnings growth of companies in the real economy. In the 1980s, the financial services sector accounted for about 10 percent of all S&P 500 company earnings. By 2006, financial services generated 40 percent of all S&P 500 earnings. That bubble is now gone too.

A sustainable national economy cannot be built on financial engineering. We need to bury the corpse of this bubble and also quickly figure out how to grow the economy the old fashioned way.

All statistics and comparisons above are from Martin Hutchinson here.

Update on Tuesday, November 25, 2008 at 06:21AM by Skeptic

For the iconic image of this bubble and commentary by Michael Lewis, author of Liar's Poker, go here.

Update on Thursday, November 27, 2008 at 01:08PM by Skeptic

Edward Hadas says the financial share of GDP can outgrow the real economy for a while.  However, reversion to mean (and probably below the mean) is inevitable.