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RPT-COLUMN-Equity prices and stories about the economy: Kemp

Reuters | Updated: 12-07-2019 05:31 IST | Created: 12-07-2019 05:30 IST
RPT-COLUMN-Equity prices and stories about the economy: Kemp
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Policymakers, financial salesmen, market commentators and journalists all tend to over-interpret short-term movements in equity prices to support simple narratives about economic success and failure. The U.S. S&P 500 index traded above 3,000 points for the first time on Wednesday and has closed at a series of record highs this month, prompting an outpouring of commentary about the strength of the U.S. economy.

But most of it ignores the fact equity prices have exhibited a persistent upward trend for at least a century, with the index setting new records on a regular basis. Focusing on new highs mistakes a long-term trend for a short-term signal about the current state of the business cycle and policy success or failure.

The S&P 500 has closed at a record high eight times so far in 2019, compared with 19 times in 2018, 62 times in 2017 and 18 times in 2016. In the last nine decades, the S&P 500 and its forerunners have closed at a record high on an average of 13 days each year (https://tmsnrt.rs/32lDuqE).

Looking at a very long time series back to 1928, the index has followed a fairly well-defined upward path with relatively modest deviations around the long-term trend. Bull markets pushed the index well above trend in 1929, 1937, 2000 and 2007, but in each instance they were followed by sharp corrections and a reversion to trend.

TREND REVERSION

The trend performance of the equity market is not surprising since equities are a claim on residual corporate income.

Corporate income in turn is linked to nominal gross domestic product, which has also trended upwards with relatively minor short-term deviations since the Great Depression, thanks to a combination of real output growth and inflation. The persistent upward trend in nominal GDP and equity valuations is the fundamental basis of passive index-investing theories, which have increasingly replaced active management and stock picking.

Record index closes therefore provide little or no information about the quality of economic policy, the health of the economy or the phase of the business cycle, despite the popularity of such narratives. Positive or negative deviations from trend, on the other hand, can provide an early warning about the risk of a future trend reversion because they tend to be unsustainable in the medium- and long-run.

U.S. equity prices are currently slightly above trend, but the deviation is small, and the market does not look as far out of alignment as in earlier episodes.


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