After reaching an all-time high in June, the stock market did it again in early September. But in September, the stock market also followed up with a plunge of almost 11%.
The decline was abrupt, scaring professional and amateur investors alike. Given the stock market's reputation as a leading indicator, does this signal that the economy is in trouble?
As a forecaster of the economy's performance, the market gives off many false signals. If we take substantial declines in the market as forecasts of recession, the market has predicted twice as many economic declines as have actually occurred.
Turn the question around and the evidence is more reliable. If we ask whether all economic recessions have been preceded by down stock markets, the answer is a timid yes; timid, because the timing has varied significantly.
The market has fallen well before the economy at times and fallen in tandem with the economy at other times. Thus, the relationship between the market and the economy is far from perfect.
Even so, if one knew an economic recession were near, it would be smart to sell stocks. Because I do not foresee an imminent recession, I do not believe that will prove to have been the reason for September's market decline.
When the market fell so sharply last month, a lot of observers blamed the "machine-based" approach to investing, which makes use of futures contracts on stock market indexes such as Standard & Poor's index of 500 stocks.
Such a futures contract allows a trader to buy or sell the equivalent of a large amount of the stocks composing the S&P index. Using computers to monitor the value of actual "cash" stocks alongside the value of stock index futures contracts, professionals have used the futures market aggressively either as portfolio insurance or in arbitrage between the cash and futures markets.
Because the futures market is so volatile, it is conceivable that aggressive selling of futures could quickly snowball into a steep drop in that market, which would then pull down the cash market for stocks with it.
Conceivable but not convincing. There were plenty of traditional worries to account for a selloff. So man, not machine, probably started the September decline in stocks.
During the summer, bond yields stopped declining and started back up. West Germany and Japan continued to resist joining the United States in a discount rate cut.
The tax reform bill raised numerous uncertainties about both the economy and the prices of financial assets. The continued decline in the dollar caused many observers to wonder whether foreign investors would continue to risk purchasing U.S. financial assets.
Economic developments are not the only concerns of the market. It is influenced as well by its own valuation measures.
The average price/earnings ratio on stocks--that is, the price of a stock divided by its annual earnings per share--is currently near 15, which is right around its long-run median level of 14.5.
However, the dividend yield on the S&P 500 index is currently 3.4%, less than half that on a high-yielding corporate bond and well below the long-term average stock yield of 4.1%.
The market is currently selling at 1.9 times book value--a measure of the underlying asset value of the stocks. From 1975 to 1984, the price-to-book ratio did not exceed 1.5, and its long-run median level is 1.43. Thus, based on how it is historically valued, the market does not appear "cheap."
What is more, despite September's drop, the market in mid-October was still 27% higher than it had been a year earlier.
'High' Valuation of Market
All these measures of the market's valuation are inconclusive about where it is heading. Such measures are above the long-run levels as often as they are below it.
If the future for the economy, corporate earnings and interest rates looks good enough, it is natural for the market to look "high" by these measures.
A further clue about the collective thinking of the market is available from its own internal dynamics--which stock groups do relatively well. During the first four years of the present bull market that started in the summer of 1982, stock in companies that would benefit from disinflation outperformed the market average substantially.
Drugs and utilities outperformed by 20% and financial stocks by 97%. By contrast, the stock performance of manufacturing and natural resource groups, most notably energy, suffered.
In August this year, the market experienced a change in group leadership, which continued during the September correction.
In this period, the manufacturing and energy groups did better than the averages.
Should the lower value of the dollar start to have a significant positive impact on the manufacturing sector, coupled with further increases in the prices of raw materials and industrial commodities, this change in group leadership could last for a while. Tomorrow's winners could be yesterday's losers.
Because I foresee the weaker dollar leading to such an economic outcome, with continued economic expansion rather than imminent recession, that kind of development among stock groups seems plausible.
But a word of warning. Major changes in market leadership rarely occur smoothly. They suggest major changes in perception of investors and in actual events. And they often involve a decline in the overall market during the transition.