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Bob Cunneen, Senior Economist
“Wall Street indices predicted nine out of the last five recessions! ".
Paul Samuelson , MIT Professor and Nobel Prize for Economics winner , Newsweek, Science and Stocks, 19 Sep. 1966.
The past few years have seen a remarkable bull run for US shares. Investors have benefitted from stronger US economic growth, particularly following President Trump’s tax cuts.
However recent market volatility has seen investors question whether this US share market surge is sustainable.
The old adage ‘time in the market’ tells us that share prices rise over time. Yet how much of the US share market outperformance has been a result of stronger US economic growth, exuberant sentiment or just investors pushing markets to valuation extremes?
Are there any key inter-relationships between the economic cycle, sentiment and valuations which can help investors better understand how markets behave?
The US share market is renowned as having astonishing fluctuations in value. History shows that US shares rarely sit calmly, moving dramatically beyond any measure of fair value. Typically shares are viewed as either cheap or expensive. A common measure of a share’s value is its Price to Earnings (P/E) ratio. This is calculated by dividing a company’s price by its earnings and indicates how much investors are prepared to pay for a dollar of earnings. Using P/E ratios, Shiller & Campbell calculate a ‘CAPE’ ratio which is the 10 year average of the price to earnings (P/E) ratio of companies listed on the US share market, adjusted for US inflation (1) *. For the past century from October 1918 to September 2018, the CAPE ratio has averaged 17.2 which is considered a measure of the US share market’s ‘fair value’. Chart 1 shows actual US share prices have significantly moved away from this measure of fair value as seen in the past century’s pattern of ‘bull’ and ’bear’ markets.
Notably after the ‘Roaring Twenties’ rally, the US share market peaked in October 1929 with the CAPE ratio reaching 32.6. Wall Street then painfully plummeted in the ‘Great Crash’ and subsequent ‘Great Depression’ to a low of 5.6 in June 1932. The late 1990s ’Dot.com’ era saw another extraordinary bull market where the CAPE peaked at 43.2 in March 2000. The subsequent bear market saw the CAPE ratio fall to a low of 21.2 in March 2003. These are exceptionally large swings in the CAPE measure - swing so huge they cast considerable doubt on the immediate relevance of any measure of the share market’s value. Arguably, value seems to be relevant only to the very patient long-term investor. US shares appear to be driven over short periods by factors other than value.
Chart 1 – US Shiller CAPE Ratio
Source: Robert Shiller online data, Yale Scholl of Management
So what are the key drivers of these sharp share price swings? The usual suspect is sentiment. Sentiment is essentially the varying perceptions of investors in the share market through time. The two most extreme examples of sentiment are fear and greed. Greed sees buyers drive share prices well above any measure of fair value, while fear can see frenzied selling that sees share prices plunge into the depths of despair.
Sentiment has three components: confidence, concerns and convictions.(1)* A rising share market typically reflects high investor confidence, low levels of concern about economic policy as well as strong conviction reflected in high share allocations by investors and traders. However sentiment just by itself cannot serve as a consistent basis for assessing whether shares are fair value. If an investor follows sentiment alone, then their portfolio can find itself hostage to events. Following the crowd can be painful when sentiment turns negative and fortunes reverse.
Beyond value and sentiment, another critical contributor to share price movements is economic growth. As corporate profits (ie the earnings component of the P/E ratio) are driven by economic growth, then economic growth should be a key factor in share price changes. Yet there seems to be an arbitrary and capricious relationship between economic growth and share prices. Periods of strong economic growth may be characterised by rising corporate sales revenues, but they could also be marked by higher costs that can heavily reduce corporate profits. These higher cost pressures could reflect rising wages, slower productivity growth, surging commodity prices, or a combination of all of these factors. Hence strong economic growth by itself may not be a beneficial tailwind to share prices.
Is there a ‘special relationship’ in some form between US share prices and economic growth? The distinguished economist Paul Samuelson famously noted that the US share market has a habit of over-predicting recessions reflected in sharp share market falls. Sometimes share market falls have preceded economic downturns and sometimes they are a false signal of doom. There is also no accepted economic theory to judge which indicators of economic activity and growth should be used to test whether a relationship exists with share prices. A range of measures for economic growth can be employed such as Nominal Gross Domestic Product (GDP), Real GDP (which is Nominal GDP less inflation) or leading economic activity indicators (eg housing construction). Also debatable is what time period the data should be examined over ie monthly, semi-annual, annual or a decade. Hence the following analysis should be read with a sceptical eye. It’s not advisable to rush out and buy or sell US shares based on the following analysis of this ‘special relationship’.
In our analysis we’ve used the US share market benchmark index, the S&P 500, over the past 20 years from 1998 to now. We take the six month change in the S&P 500 to capture the short-term moves in US shares. As seen in Chart 2, the large positive changes can be identified as large bull markets (eg 1998-2000, 2004-07 and 2009-2017). Conversely large negatives are bear markets. The dramatic negative returns from March 2000 to 2003 (September 11 terrorist attacks and the Iraq War were key events as well as US accounting scandals with Enron & World Com) are evident with six month price falls of up to 30%. The Global Financial Crisis from August 2007 to March 2009 is the most dramatic recent shock to Wall Street which featured 30% to 40% falls from October 2008 to March 2009.
Chart 2 – US Share Market Cycle – Standard & Poors 500 Index
Source: Standard & Poors.
To gauge the US economic cycle, a composite of eight leading economic activity indicators are used to assess whether growth is accelerating or slowing. These US indicators include business surveys, consumer sentiment, housing construction, car sales and working hours. The economic cycle measure ( red line in Chart 3) takes the latest result and then compares this to its recent six month average (3)*. We then assess this measure of the economic cycle against movements in the share market by calculating their correlation. Over the past 20 years, the correlation is 0.7 meaning this economic cycle indicator can be considered highly informative on US share prices moves; suggesting that US shares are a sensitive barometer to changes in the economic cycle. There appears to be some ‘method in the madness’ of US share prices.
Chart 3 – US Shares vs Economic Cycle
Sources: Standard & Poors and Federal Reserve, St Louis.
The key question that investors needs assurance on is whether the economic cycle data confirm or conflict with Wall Street’s performance? When there is a widening divergence between the economic cycle and current share market returns, investors need to be concerned. For example, the deteriorating US economic cycle performance in 2006 and 2007 suggested that recession risks were building - a warning sign for share investors ahead of the ‘Great Recession’ and ‘Global Financial Crisis’ in 2008-2009.
However readers need to be careful that this economic cycle indicator cannot precisely forecast the magnitude of current or future US share price changes. This economic cycle indicator is not a money-making machine. US shares may have already largely incorporated the current economic cycle results. There can also be a very complex interaction between the economic cycle and share prices moves where they can amplify each other through a feedback process. So determining causation and response between the economic cycle and share price cycle is a very intricate process that requires further research.
In the closing months of 2018, what do these respective US share indicators suggest? Firstly the Shiller & Campbell CAPE measure at 30.6 seen in Chart 1 shows US shares are very expensive. US shares are priced well above the past century’s CAPE average of 17.2. The US sentiment measures also are very extended given exuberant investor surveys and households having a high historical share allocation. So on the basis of both high valuations and very positive sentiment , US share investors need to be wary of the downside risk of share markets.
Currently the economic cycle indicator shows that US economic growth is neither accelerating nor slowing, so is considered neutral. Yet there are some early signs in some of the economic cycle indicators that the current US growth surge with President Trump’s large corporate and income tax cuts is starting to lose momentum. US housing construction is softening as the immediate sugar hit of lower taxes meets the reality of higher lending interest rates and government bond yields. Should the US economic cycle indicator start to slide into negative territory over the next year as US growth slows, then the US share market is vulnerable. The recent turbulence in October and November 2018 with the S&P 500 falling by circa 7 % and the NASDAQ by 9 % may be the first painful instalment in a coming bear market for US shares.
1) According to Journal of Portfolio Management (2017), “ Robert Shiller and John Campbell introduced one of the most powerful measures of value when they developed the cyclically adjusted price/earnings ratio (CAPE) or Shiller P/E. The Shiller P/E divides the current real price of a broad market index by a 10-year average of its inflation-adjusted earnings.”
King of the Mountain: The Shiller P/E and Macroeconomic Conditions , Robert D. Arnott, Denis B. Chaves and Tzee-man Chow . The Journal of Portfolio Management Fall 2017, 44 (1) 55-68; DOI: https://doi.org/10.3905/jpm.2017.44.1.055
2) * Measuring Fear and Greed on Wall Street
3) This economic cycle measure is then standardised by calculating a “Z score” which is the variable’s difference to its long-term average that is then divided by its standard deviation.
This communication has been prepared by MLC Investments Limited (ABN 30 002 641 661, AFSL 230705) (‘MLC’), a member of the National Australia Bank group of companies (‘NAB Group’), 105-153 Miller St, North Sydney 2060. The communication is not intended to offer products or services provided by any member of the NAB Group. Any advice and information in the communication is of a general nature only. Opinions constitute our judgement at the time of issue and are subject to change. Neither MLC nor any member of the NAB Group, nor their employees or directors give any warranty of accuracy or reliability, nor accept any responsibility for errors or omissions in this presentation. An investment with MLC does not represent a deposit or liability of, and is not guaranteed by, the NAB Group. In some cases the information has been provided to us by third parties. While it is believed the information is accurate and reliable, the accuracy of that information is not guaranteed in any way.