Steve Blitz Morning Notes

A number of articles, on the web and off, have recently come out trying to tie the current equity market price pattern to 1930 -- meaning that another big downturn is coming and a new low is in the offing. Technical analysis of market activity has value because price action often presages fundamental events driving valuations simply because market participants in total react to what is going on before the government can officially report on it. That being said, tying patterns across decades is poor analysis and misses the important question -- what is the performance of equities going to look like in the coming years.

The equity market is always more nervous than the economy and that is exactly what happened to the market in this cycle. The spring swoon reflected an all out view that the economy was about to tumble into the abyss. As extreme negative sentiment subsided the market improved to levels reflective of a weak economy not depression. Current levels for the S&P 500 match the late 2003 levels. To believe the market is now pricing in a V-recovery is just silly.

Evidence of the market's skittishness relative to GDP is shown in the scatter plot charts below comparing year-over-year percent change in GDP to the annual change in the S&P 500. The first chart covers annual data beginning in 1896 and the other covers quarterly data beginning in in 1947. In each time frame the range of year-over-year percent change in the S&P 500 is far wider than it is for GDP. There are even periods of positive GDP growth and a falling stock market. I like looking at a long time frame because it covers every possible market and period of market regulation and tax changes.





In terms of understanding just how the market is currently priced, knowing now that it can go askew quite a ways from economic reality, the chart below is the ratio of the S&P 500 to GDP from 1896 to present -- with the recessions shaded in. I first began using this chart in the early 1990s to prove out that the equity market was returning to its late 1950s - early 1960s valuation against GDP as the economy returned to the low unemployment low inflation environment of that period -- rather than irrational exuberance.

The ratio is too low to believe the market is optimistic on future growth and hence overvalued to the extent that a 1930 decline is in the offing. More important is that this ratio is unlikely to rise anytime soon -- meaning that profit expectations are going to lag the economy. The mix of an expansive monetary and fiscal policy is the culprit. This is not to say the current policy mix is poor policy at the present, it isn't. The problem is that I don't see an unwind when the economy begins to recover and the equity market lags the economy when monetary and fiscal policy is expansive (World War I, World War II, 1966 to 1979). We have been in an expansive environment since the beginning of 2001 and the market has underperformed.

The stock market is now going to cycle about in the current range for some time to come, at least until there are better and more broad indicators of resurgent growth. When the economy bell rings market indexes will rise but the policy mix effectively guarantees that equities as a whole will underperform the economy.