Latest U.S. economic data came in softer: last week's employment numbers were disappointing, while ISM Services ticked marginally lower. Markets went up - on a combination of bullish central bank comments from Dudley, short covering, a jump in oil prices, good weather, and whatever else journalists invent to rationalize price movements on the fly.
Nevertheless, equities had a good day and it takes a certain level of conviction to buy equity beta here as equities are certainly not cheap: the S&P's trailing P/E ratio is around 20, the Shiller cyclically adjusted P/E is around 27 (if you believe in a cyclically adjusted P/E), and forward P/Es have to be taken with a grain of salt due to perpetual analyst revisions. How disconnected are equities from real economic growth?
Equity price performance depends - at least in part - on real earnings growth, and earnings should be reflected in GDP somehow. Ignoring lead/lag effects and timing issues, the chart shows U.S. real GDP vs. the S&P 500 (both year-over-year percentage changes).
Using quarterly data frequency, the correlation of the two series since 1958 is 0.45; the correlation since 2009 is in excess of 0.8. The median real GDP growth is 3.2% while the median YoY price change for the S&P 500 is 9.3%. Since January 2009, the median real GDP growth is 1.9%, and the median YoY price change for the S&P 500 is 12%.
Real GDP growth is below its long-term median while median price changes for the S&P are well above the long-term median of 9%, i.e., the economy is growing slower than normal, while equity prices are increasing faster than normal. While this dichotomy may continue for a while, it is indicative of asset price inflation.
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