Tuesday, 24 March 2015

Bubble Extraordinaire

We have long since established that the U.S. stock market has completely dislocated from many economic indicators (here's a selection). The inflationary policies, nurturing low interest rates and increased money supply, making ordinary bank savings a sure loser, have no doubt helped pushed the stock market into "I'm all in and hope for the best" territory. 

As we've seen many times throughout history, the stock market can stay overvalued much longer than one would perhaps think "rational" and "risk averse" investors would endure. Eventually however, certain basic relationships between the stock market and the economy as a whole need to revert toward more reasonable levels. 

The chart below shows the relationship between the Wilshire 4500 stock market index and the U.S. weekly leading index published by the Economic Cycle Research Institute. This leading economic index attempts to predict turns in the economy (i.e. predict the business cycle). As of 13 March, the indicator has declined on a y/y basis for 13 consecutive weeks, i.e. every week this year. Prior to this, the index increased 118 weeks in a row on a y/y basis (24 August 2012 to 21 November 2014). Currently, the index is 1.3% lower than same week last year. 

The Wilshire 4500 index on the other hand has now increased every single week on a y/y basis for 138 weeks starting 3 August 2012. The most recent reading shows a 10.5% increase compared to same week last year. Result? Since the beginning of August 2012, the stock market has increased 74.1% while the leading index for the economy has only increased 7.3%. The stock market has hence outpaced the economic index more than 10-fold during this period. But it gets worse: going back to the previous stock market peak in October 2007, the stock market has since surged 79.9% while the leading economic index has, wait for it, declined by 6.6%, leading to a 92.5% jump in the ratio between the two. 


One could argue that the above ratio reflects expectations of future improvements in the U.S. economy. The leading index, which has a reasonably good track record, is however telling us that not only is the U.S. economy weaker today than back in October 2007, but it's also weaker today than one year ago. 

With ever increasing government debt and a U.S. economy fuelled by centrally planned low interest rates and inflationary monetary policies, there are currently few good reasons to expect a progressing U.S. economy over the near to medium term. Only a falling stock market can therefore bring the above ratio down towards a more reasonable level and it might very well have to catch up with a future (sharp) fall in the leading index, too. It's just a matter of time.