Market Note April 2021
Best Leading Economic Indicator; The Stock Market
In regular conversations with clients and firm advisors over the past few months, I’ve continued to emphasize that underlying economic conditions are NOT a leading indicator or predictor of stock market returns. In fact, it is quite the opposite; the stock market is the best leading indicator of the underlying economy. If you track economic measures such as employment, GDP, and other fundamentals of the U.S. and global economies, you are very likely to miss the stock market’s upside.
As evidence of this, take a look at the chart of world gross domestic product, with the first quarter of 2021 denoted as a forecasted number (dotted portion of line). If investors waited to invest in stocks by the time GDP recovered, say 75% of its decline from pandemic driven lockdowns, you wouldn’t have bought stocks until the third quarter of 2021. You would have missed a very large portion of the stock market’s returns after the March 23, 2020 COVID bottom.
If an investor waited until the level of domestic economic output was equal to the levels where we left off prior to the pandemic, you’d still be waiting to invest in stocks. The point is, the stock market has always been forward looking, rising before the economy “feels good” and falling before we know there is trouble at hand. If you’re trying to win a prize for forecasting the underlying economy, by all means use the stock market as your key indicator!
Many have also asked where do stocks go from here? A fair question given current stock prices and valuations. I think a more accurate interpretation of this common query is at these prices is the market due for a temporary correction in the midst of an otherwise stronger and improving economic recovery?
Fact is, we’ve already experienced a 10.5% correction on the tech heavy NASDAQ index, as you can see in the recent decline from peak to trough on the year-to-date chart of the index. If we peel back the layers that caused the index’s correction level-decline, we note it was driven by a sudden doubling of the 10-year U.S. Treasury bond yield, on which future profits and cash flows are discounted to arrive at valuation estimates for stocks and other assets. The individual companies that make up the NASDAQ Index continue to do just fine, with rising sales and profits. But, when you introduce the uncertainty of interest rates/discount rates on top of the already imprecise science and art of forecasting companies’ sales and profit growth, investors begin to recalibrate potential outcomes.
Japanese investors are the largest buyers of U.S. government securities. You may be thinking it is China, a common misconception. Earlier this year, as the yield on U.S. treasuries (let’s use the 10-year yield as our example) remained persistently and historically low (well under 1%), Japanese and other government securities became a more attractive risk-reward set-up resulting in a drop off in Japanese purchases until yields rose to around 1.3%. Demand dropped off, and supply rose as the U.S. treasury continued to auction securities.
I think it is also important to understand that the natural direction of the stock market is upward. Think about it. The Dow Jones Industrial Average has risen from less than 8,000 in 2009 to 34,137 today. That’s nearly five times where it was in 2009! Market downturns don’t last long compared to periods of rising markets. There are legions of corporate executives, employees, shareholders, creditors, and others cheering on companies and their stock prices, as they power forward with their own career and financial ambitions. Unless the global population descends into a downward spiral, the long-term direction of the markets is certainly higher.
At First Trust Portfolios, a $150 billion assets under management asset manager, Chief Economist Brian Wesbury makes a case for another 7.5% or so on the S&P 500 from now until the end of 2021. His forecast is contingent upon a steady 10-year treasury discount rate and the continuing opening of the U.S. and global economies. We concur with Brian’s prognostication and contingencies. As Brian also points out; that doesn’t mean investors won’t experience a correction or volatility along the way. As indicated above, we’ve already experienced a technical correction of more than 10% on the NASDAQ index. What it does mean is that for new cash on hand waiting for investment, a correction would be a buying opportunity not a selling event with what we know today. While there are certainly many individual stocks that have traded to prices beyond probable future business growth, the market, as a whole, remains fairly valued given the current interest rate environment. We think remaining invested in what you already own makes a lot of sense, while using any corrective activity to put fresh cash to work in a patient manner. We are certainly not feeling the excitement of investing at April 2020 valuations, there are sufficient reasons to remain invested in accordance with a portfolio positioned to achieve your long term financial and life objectives.
As always, for further discussion on this topic and others, please contact your Integra Capital representative. We hope this finds you and your family doing well and in good health.
The information contained herein has been obtained from sources believed to be reliable but the accuracy of the information cannot be guaranteed, nor should it regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of thoughts and opinions on investment topics. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.
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