Expect more headwinds for the US stock market
By Lars Christensen, Markets & Money Advisory Founder and CEO, LC@mamoadvisory.com, @
2018 hasn’t been a good year for the US stock market and we expect more volatility going forward. We might very well see new lows in the coming months.
Judging from the general media coverage the reason for stock market volatility primarily has to be found on Pennsylvania Avenue 1600 - i.e. in the White House - and there certainly is no doubt that President Trump's mostly ill-advised tweets scare investors. However, it is also worth noting that investors ignored Trump for a very long time.
If we are to analyze developments in the stock market, then it might be more reasonable to focus on factors that normally drive the stock market instead of focusing on the daily blunt attacks from the US president.
Basically, there are three factors that drive the stock market over the longer term. First, earnings development and expectations for future earnings (positively). Second, the development of interest rates (negatively) and, thirdly, what we call the risk premium (negatively).
We have used these three factors to estimate a simple model for S&P 500. In the model we use potential nominal GDP as a proxy for long-term earnings growth. We use corporate bond yields as our measure of interest rates and we estimate the risk premium by looking at macroeconomic (in)stability measured as the volatility in quarterly growth of nominal GDP.
As the graph below shows the model does a good job explaining the overall trends in S&P 500 since 1970 and we see that through most of this period the actual level of S&P500 is within one standard deviation of the model ‘prediction’.
All three factors have supported the US stock market performance since 2009-10, but in recent months development has begun to reverse.
Firstly, the US Federal Reserve has begun to signal a more aggressive tightening of monetary policy in the forefront of inflationary pressures. It reduces expectations of US growth and thus also earnings development in US companies. At the same time, US long-term interest rates have already risen somewhat since autumn - mainly due to a significant easing of US fiscal policy. Upon of that it is also clear that the noise from the White House naturally contributes to increasing the risk premium on American stocks.
Taking all this into account, the US stock market has simply become too expensive. This does not mean we should start screaming bubble, nor does it mean that the US stock market necessarily will drop sharply, but the tailwinds we've seen since 2009-10 should not be expected to continue going forward.
How the US stock market performs for the rest of the year will largely depend on the expectations of the performance of the US economy and in this connection it is important to stress that it is not primarily Trump we shall keep an eye on, but rather Fed chief Jerome Powell.
It is thus notable that Powell has signaled that the Fed will continue the interest rate hikes not only this year and next year but also in 2020 and if the Fed actually delivers the rate hikes, which it de facto has signaled it will then the Fed will effectively push short-term rates above 10-year yields during 2019-20.
Historically, every time - since World War II - short-term interest rates have risen above long-term interest rates and the yield curve have become inverted it has led to a recession in the US economy.
We know what a recession means for earnings. So, if the Fed actually does what it has threatened to do in terms of rate hikes then we could face a recession in 2020-21. Any sign of such a scenario will make it obvious for investors to run away from the stock market screaming- even before the recession hits.
Now, fortunately, it is not certain that Powell & Co. deliberately want to send the US economy into recession, but at the moment it seems that investors are increasingly fearing such a scenario. And that in our view is a well-founded fear.
Going back to our model, we view the predicted level of S&P 500 as a measure of the ‘fair value’ for the US stock market. That is, the level of S&P 500 which is consistent with the development in current and future earnings, interest rates and the risk premium.
Combining our measure of the fair value as well as the actual level of S&P 500, we have constructed a Valuation Indicator for S&P500. When the indicator is above (below) zero the actual level is above (below) our measure of the fair value indicating a current overvaluation (undervaluation).
As the graph below illustrates, our Valuation Indicator has been quite close to zero since 2014 but it has been inching upwards since the end of 2016. In the start of the year it reached the critical level of one standard deviation, signaling an increased risk of a sell-off, which subsequently was realized.
In a historic perspective, the Valuation Indicator clearly illustrates the overvaluation of stocks in 1998-2000 as well as the undervaluation in 2008-2010. What we currently see are US equities being just on the edge of a slight overvaluation.
Taking into account the recent increases in corporate bond yields as well as well as a higher risk premium it would certainly not be surprising if we see US stock prices decline further. This of course particularly becomes a likely scenario if the Fed moves closer to ‘murdering’ the economic expansion.
Going forward, we will continue to keep an eye on our framework to track the development in US equity markets and we are happy to discuss our model framework with both present and future clients.