News in Charts: Like a bridge over troubled water: the macro cycle and equity valuations

Fathom’s US Economic Sentiment Indicator (ESI) provides a powerful summary of various economic sentiment measures gauging the health of the macroeconomic cycle as well as market gyrations.

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Just as importantly, the US ESI also works well at highlighting periods of strong versus low risk-adjusted returns over the economic cycle at forward horizons of up to 12 months. This finding is driven by the ESI being a good proxy for systemic risk. At cyclical extremes, systemic risk tends to dominate asset returns for some time before mean reverting. Conversely, the impact of systemic risk on asset prices is drowned out by more idiosyncratic factors in periods between extremes (i.e. normal periods).

Combining the ESI with market valuations (using the cyclically adjusted price-to-earnings ratio, CAPE for short), provides a road map for the likely path of equity prices over the next 18 months. Over this horizon, we find that equity prices are set to remain positive but volatile, consistent with the current expensive valuations and the strong cyclical macro conditions highlighted by the ESI. In practical terms, we continue to expect more of the same jittery market conditions that have taken hold since February this year.

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Beyond the next 18 months, empirical evidence suggests that risks in equity markets increase substantially the longer valuations stay expensive. We would recommend that readers keep an eye on any deterioration in the macroeconomic cycle, as flagged by our own ESI, for further evidence of a correction over the next 24 months.

It is Fathom’s view that when the correction materialises it could lead to equity markets shedding as much as 40% of their value. Using the framework of a simple dividend discount model, we reached this figure by asserting that investors’ expectations about the long-run real rate of interest would move into line with investors’ expectations about trend growth across the major economies. The ‘r-g gap’, in short, would close, just as it always had in the past.

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