Recently, I wrote about the prospects for economic growth through the end of 2013. Today, I connect this picture of the economy over the next twenty-one months with the performance of the stock market.
This has been an interesting week for the United States stock market. The S&P 500 closed above 1,400; the Dow-Jones index closed above 13,000; and Nasdaq closed above 3,000. The stock market seems to be headed upwards.
The question needs to be raised about whether or not a rise in the stock market can be considered to be consistent with my view of the economy through 2013. Thursday I wrote that I believed that real GDP in the United States would grow over the next two years or so in the range of 2 percent to 3 percent, year-over-year. My basic feeling is that the growth rate will tend to be closer to 2 percent over this period than to 3 percent.
There are a lot of “unknowns” that could affect this outcome, but it appears to me that the policy makers, at least those at the Federal Reserve, have taken many of these into consideration, thus these unknowns are “known unknowns", and are attempting to error on the side of too much ease to prevent the economic system from being shocked or surprised in a way that will block the recovery.
One, of course, can never be fully prepared for a war in the middle east, or an economic collapse elsewhere. If something like this were to occur, then all bets are off.
Thus, the underlying picture of my economic forecast is that the monetary authority will err on the side of ease and the fiscal policy of the United States government will be vague, but will pile up deficits in excess of one trillion dollars for the foreseeable future.
The immediate question this raises in my mind is that of financial bubbles. Over the past two years or so there has been considerable concern about the funds the Federal Reserve has pumped into the banking system. In November 2009 excess reserves in the commercial banking system exceeded $1 trillion and has remained above this level ever since. The latest Fed data show that excess reserves now stand between $1.5 trillion and $1.6 trillion.
Given this liquidity in the banking system and the consequent low interest rate targets the Federal Reserve is working off of, a considerable amount of concern has existed over the past two years or so about bubbles being created in various markets around the world, like commodity markets and the markets for the securities of emerging countries. This concern still remains.
If there have been bubbles in these markets, could we not assume that a bubble might exist in the United States stock market as well?
Robert Shiller of Yale University has produced a statistic that he calls CAPE, or, the Cyclically Adjusted Price Earnings ratio, related to the United States stock market. The basic idea presented by Shiller is that this ratio will vary cyclically but will tend, over time, to eventually revert to its mean average. The long-term average of ratio is around 14.0.
In February, CAPE, as calculated by Shiller, was 21.64. (Note: Shiller delivers these data online at his website.) Hence, the current level of the CAPE measure is substantially above its long-term average. One could say that it is about 50 percent above its long-term average.
Before one jumps to the conclusion that I believe that the market is way overvalued and needs a correction, let me say a couple of things. First, as Shille himself states, CAPE can stay over or below its long-term average, in fact it can stay way over or way below its long-term average, for a long time. Being over or under the average does not mean there will be an immediate reversion to the mean. In fact, it can stay over or under the mean for longer than you can afford to hold a position betting against it.
Second, if CAPE is over or under the mean, it is important to try and understand why it is in such a position. For example, because CAPE is adjusted for its variations over the longer term, it tends produce some lags in its response. In this case, the earnings variable is lagged over an extended period of time and will therefore tend to be somewhat behind the cycle. Thus, if stock prices rise in anticipation of a growth in earnings, the ratio may tend to rise ahead of earnings growth with the idea that it will fall in the future as earnings actually catch up with the expected earnings captured in earlier price increases. In cases like this the cyclical behavior of earnings will eventually bring CAPE into line with its longer-term average.
However, if there is a bubble in stock prices, the earnings will not catch up with the initial rise in prices and the stock prices will eventually have to fall to bring CAPE back into line with its long-run average.
One can look at other factors in the financial markets in an attempt to determine whether or not CAPE will revert to its mean sooner rather than later. There are two particular measures of financial markets that I have worked with in recent years that provide some help in understanding the performance of the stock market. The first I call a confidence index and the second I call a liquidity index. (I will explain these two measures in future posts.) If both indices are rising, then the S&P 500 index tends to show pretty good gains, 10 percent or more, and CAPE can be expected to remain where it is for the time being. If both decline, then the S&P 500 index will fall, 10 percent or more, and CAPE can be expected to revert toward its mean. If the measures are mixed then the S&P 500 index seems to fluctuate over and above a zero-growth rate.
Last year this confidence index reached a near term peak in June and declined throughout the summer and fall until February of this year. It has since risen into the middle of March. The earlier period coincided with a lot of uncertainty in the US economy and with the rising concern about the European sovereign debt situation. The pick-up in confidence came about as economic information seemed to improve and as the situation in the eurozone with respect to Greece improved.
The liquidity index dropped through much of 2011 and bottomed out in December. This index has been rising since then into the middle of March. The decline occurred because so much money went into Treasury issues from other issues in the financial markets, a “move to quality”. Over the past few months we have seen a reversal in this as funds have flowed back into these other issues making the market, as a whole, more liquid.
So, right now, I believe that the US stock market is in for some further upward movement. I expect to see the economy continue to grow, although modestly, and I expect that monetary policy will remain on the side of cautionary ease -- but, we will not see QE3. Measures of financial market confidence and liquidity are both positive and I am expecting they will remain so in the near term. This means to me that even though CAPE is above its long-term average it is in no danger of dropping due to the price of stocks falling to bring them back into line with the long-term movement in earnings.
My best guess for the stock market, then, barring any unforeseen shocks, is for the S&P 500 index to rise by at least 10 percent, year-over-year, for the next eighteen months or so.