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Confusing a boom with stock market potential

Posted by: Brian Dennehy
Membership level: Free

 

[This was part of the latest TopFunds Guide, released January 2018]

“Boom times return for the global economy”.

“The global economy has grown strongly in 2017 and will remain strong in 2018.”

This is the positive mantra of many analysts and fund managers. Those same analysts, headline writers and cheerleaders extrapolate from this that stock markets will head higher.

The problem is that the link between economic growth and stock market strength is (counterintuitively) weak.  This can be quite complex. Academics regularly cross swords on this subject. But two features do appear consistent:

  • Investors are typically better off investing in the more sluggish economies (based on research by LBS of 19 major countries, 1900-2011)
  • Investors typically over pay for growth (because by the time economic growth actually appears, stock markets have already allowed for it in share prices)

Another light was shone on this recently by new research from Robert Shiller, who is responsible for the cyclically-adjusted price earnings ratio, CAPE, to which we have often referred as a measure of stock market value. On this occasion he was exploring the 13 bear markets since 1871, and the conditions preceding each of them.
CAPE peak - historical vulnerability

The CAPE ratio is now above 30, and has only ever been that high before in 1929 and 1997-2002. Before prior bear markets CAPE was always above the long-term trend, and averaged 22.1, but for wars and the Great Depression. So, a high CAPE has indicated bear market vulnerability.

Turning to earnings, he observed that real earnings grew by 1.8% p.a., on average, since 1881. But before all the 13 bear markets they averaged a very high 13.3%. They are currently running at 13.2% - expecting more real earnings growth is therefore a negative indicator.

Is low volatility good news? (Volatility in this case being the standard deviation of monthly returns in the prior 12 months). The long-term average is 3.5%. The peak month before the 13 bears was lower than this, at 3.1%, and before the 1929 crash was 2.8%. Today volatility is at an extraordinarily low 1.2%. Uniquely vulnerable? We will see.
In short, the US stock market (the global bellwether) looks like it is in much the same place as it was before prior bear markets (which Shiller defines as a 20% fall within 12 months).

Plan now - both for descent and ascent

Do ignore the complacent noise from too many economists and the wider investment industry – at best it is irrelevant, at worst it will distract you at a time when your attention is vital.

If you are a DIY investor, and reasonably fully invested today, you must be prepared to be fleet of foot. Do have a stop-loss strategy to avoid the possibility of much larger drawdowns than 20%, and, equally importantly, have a clear plan to re-enter the market, very possibly at a time of deep gloom, which is not easy.

FURTHER READING

Topic: Market commentary


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