Feb 26 2024: “Disregarding GDP: Stocks Forge Their Own Path, Notes McGeever
The stock market operates independently from the economy.”
This observation rings true in today’s landscape, particularly with the remarkable surge in a select few mega tech stocks propelling Wall Street to unprecedented highs, despite various sectors lagging behind and signs of economic growth slowdown.
However, the United States continues to maintain ‘real’ inflation-adjusted economic growth rates of 3% or higher, driving nominal growth to well over 5%, while annual S&P 500 corporate profit growth exceeded 10% last year.
This might offer some explanation.
But the puzzle deepens when examining other regions. Japan recently entered a technical recession, and Europe’s economic growth has been stagnant for the past two years. Yet, the Nikkei 225 and Stoxx 600 recently soared to record highs.
When stocks reach unprecedented levels, comparisons with past peaks surface, raising questions about the sustainability of the rally and sparking discussions about bubbles.
Such concerns are amplified when the prosperity on Wall Street isn’t mirrored on Main Street. While U.S. unemployment remains historically low and last year witnessed surprisingly robust growth, few anticipate this trend to persist.
Fortunately for equity investors, the market seems to possess its own momentum, detached from the ‘real economy.’
“A more reliable indicator for markets than the macroeconomic landscape is the trajectory of corporate earnings, which currently appears robust,” remarks Justin Burgin, director of equity research at Ameriprise Financial (NYSE:AMP).
THE BUFFETT INDICATOR
During such times, metrics like the ‘Buffett Indicator’ are often used to signal the risk of a potential downturn in stock prices from their lofty peaks.
This indicator, named after legendary investor Warren Buffett, measures the equity market cap relative to gross domestic product (GDP), indicating whether stocks are over- or under-valued.
Depending on the market measure utilized, the current data suggests that the total value of U.S. stocks is between one and a half to nearly twice as high as annual GDP—historically elevated levels.
However, the index has its limitations. It compares the value of all goods and services produced in the economy over a year against an equity market cap on any given day, essentially a ‘stock versus flow’ comparison.
It fails to consider the impact of 15 years and trillions of dollars in central bank monetary support, which has inflated asset prices far beyond economic activity.
Nonetheless, according to a 2022 paper by Laurens Swinkels, associate professor at Erasmus University in Rotterdam, and Thomas Umlauft at the University of Vienna, it serves as a “crude, but straightforward” measure of investor sentiment towards stock markets versus the ‘real’ economy.
Swinkels, also the executive director of research at Robeco, and Umlauft point out that as more economic resources pour into capital markets, “equity prices are driven up without a proportional increase in ‘real’ economic activity, leading to lower expected returns.”
However, it could take years, even up to a decade, before stretched valuations result in “significant” losses, they add.
“The Buffett Indicator and others suggest concern at this point in the cycle, although they don’t predict the next 6-12 months,” notes Colin Graham, a colleague of Swinkels at Robeco.
THE CURRENT SCENARIO
Presently, equities seem to be in a favorable position – the consensus U.S. 2024 earnings growth forecast stands at 10%, and the U.S. remains the global leader in technology and artificial intelligence.
Although U.S. valuations are relatively high, they are far from the peaks of 1999-2000 or even three…
