The Economic ClockThe reality is that the stock market is a leading indicator of the economy and not the other way around. By the time the economy slows the market has already dropped and in fact may be starting to rise as it looks to the future economic rebound. Considering the economic cycles that tend to occur a rough indicator of the future maybe indicated by the economic clock.
While this is very rudimentary it is a staring point. A complete cycle is generally considered to be around 7 years. In fact from a share price perspective what the clock is indicating is to buy in gloom and sell in boom ie be a contrarian investor.
Because it is a cycle we can in fact use the economy as a pseudo leading indicator of the market:
- the time to buy is 1 cycle after the last time to buy;
- the time to buy is when the economy has slowed and interest rates are falling;
and just as importantly
- the time to sell is 1 cycle after the last time to sell;
- the time to sell is when the economy has expanded and interest rates are rising;
It is also worth considering that performance of a specific market sector is influenced by the economic cycle and is its self cyclic. This suggests there are benefits in a Sector Rotation trading strategy.
However the key may be in determining when the boom or gloom are approaching their peaks or troughs and managing market entries and exits accordingly. Can market volatility tell us anything?
Market Volatility Index
Market Volatility is often gauged using the Volatility Index (VIX). This is a measure of volatility in options prices for a basket of stocks on the S&P 500. Because it is based on options it tends to be a leading market indicator.
Lower VIX values indicate a stable market and tend to be supportive of a an underlying market up trend.
Higher VIX values indicate higher market volatility and an underlying down trend. A reversal in volatility levels from a high is a potential market bottom signal.
There appears to be some support for an inverse relationship between the VIX and the stock market and the VIX acting as a leading market indicator:
- Increasing volatility (VIX) indicates a falling market
- Decreasing volatility (VIX) indicates a rising market
We can also apply Technical Analysis directly to the Volatility Index in exactly the same manner as we do for a stock. In fact this can be undertaken for any index and provide additional insight.
Technical Analysis of an Index
If you add an index code to the Stock Price Analysis Module you can undertake Technical Analysis for the index just as you would for a stock. Applying Technical Analysis to an index can be provide insight into the overall market sentiment.
|Index||Yahoo Finance Index Code|
|Dow Jones Industrial Index||^DJI|
Why does the stock market go up?
A stock price reflects the future earnings of the company. In fact the only way a stock price can continually rise is if it's earnings continually rise. Extending this the stock market reflects the future earnings of the companies it trades and the national economy. The growth of the national economy can be measured by using its Gross Domestic Product (GDP). Applying an indicative GDP growth rate of 6% to an index we can calculate an expected index value for today .
In January 1995 the Dow Jones Industrial Average (^DJI) was around 4000, applying a compound earnings growth rate of 6% the Dow today should be .
In January 1995 the Australian All Ordinaries (^AORD) was around 2000, applying a compound earnings growth rate of 6% the All Ords today should be .
Actual market levels will fluctuate around the underlying value. If we decrease the growth by 1.5% to a compound earnings growth rate of 4.5% the Dow today should be and the All Ords today should be .
Increasing the growth by 1.5% to a compound earnings growth rate of 7.5% the Dow today should be and the All Ords today should be .
Current Stock Market Forecast Calculator
You can use the following Stock Market Forecast Calculator to forecast where the stock market would be if compound growth was applied over a period from a previous market reference point. This forecast can provide insight into potential market swings. When the market is above the forecast a bull market is indicated, when it is below the forecast a bear market is indicated. Due to compounding small variations in values applied will have significant impact on results. For best results the starting index level and year should be selected to reflect a stable mid range point within a previous market cycle. The compound earnings growth should reflect the average GDP growth for the economy represented by the index.
Actual US GDP figures since 1929 indicate average GDP of around 6.3%. GDP in 1929 was 103 Billion and GDP in 2007 was 13,807 Billion. While actual US GDP figures since 1995 indicate average GDP of around 4.6%. GDP in 1995 was 7,397 Billion and GDP in 2007 was 13,807 Billion.
Price Earnings Ratio as a Market Forecast Indicator
Lets consider what might happen to a stock's price, EPS and PE during an economic cycle. We will use a very basic approach with nice round numbers.
During stable economic conditions (ie no change) a stock with an current and future EPS of $1 per annum where investors require a 10% Return on investment the stock price will be $10.00 and the PE will be 10.
Stock Price = EPS / Required Return %
Stock Price = $1 / .1 => $10.00
PE = Stock Price / EPS
PE = 10 / 1 => 10
This is Fair Value and Fair Value PE as calculated in the Stock Price Analysis Module.
Investors then begin to believe that the economy is staring to grow so they increase what they think the EPS will be to $1.50, the stock price rises to $15.00. But because the current earnings have not increased only the possible future earnings the PE also rises to 15.
Stock Price = $1.50 / .1 => $15.00
PE = 15 / 1 => 15
So an increasing PE may indicate an increasing stock price.
If the forecast EPS becomes reality then the price holds and PE drops accordingly
PE = 15 / 1.50 => 10
So an decreasing PE may indicate a stable stock price.
This indicates in a rising stock market we would expect the PE to rise and fall over time but trend higher not lower.
Now lets consider the reverse where investors begin to believe that the economy is starting to contract so they decrease what they think the EPS will be to $0.50, the stock price drops to $5.00. But because the current earnings have not decreased only the possible future earnings the PE also falls to 5.
Stock Price = $0.50 / .1 => $5.00
PE = 5 / 1 => 5
So an decreasing PE may indicate a decreasing stock price.
If the forecast EPS becomes reality then the price holds and PE rises accordingly
PE = 5 / .50 => 10
So an increasing PE may indicate a stable stock price.
So in a falling stock market we would expect the PE to rise and fall over time but trend lower not higher.
So far it does not really tell us much but if we can determine when a market changes from rising to falling and visa versa perhaps then it is worth considering. There is some evidence that underlying changes in PE do provide some indication of changes in the market. In the article Is the P/E Ratio a Good Market-Timing Indicator? Matt Blackman back tests a buy sell trigger pattern using 2 and 5 year moving averages of PE Ratios. The trigger is changes in PE trend. This back test confirms ...
A change in underlying PE trend from rising to falling is a market exit trigger.
A change in underlying PE trend from falling to rising is a market entry trigger.
You can compare the inflation adjusted Shiller SP500 PE Ratio and SP500 Price to see the strength of the relationship.