News in Charts: Fathom’s View on the Equities Market

The route in equity markets has been a hot topic in recent days — as users of Fathom’s chartbook, hosted by Thomson Reuters Eikon and Datastream will undoubtedly know. At the time of writing, the S&P 500 has declined by 5.7% this week, erasing all of its gains since the start of the year. It was a similar story with bourses selling off in Japan, the UK and elsewhere in Europe too.

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Emerging markets experienced similar sell-offs this week with Chinese equities being among the worst performers (down 9.5% by the time the market closed).

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The declines in equity markets encouraged some investors to move money into safer assets, with both the Japanese yen and the US dollar strengthening this week. Sterling did, however, regain some value against the dollar following a somewhat hawkish tone from the Bank of England’s Inflation Report which highlighted the possibility that interest rates could rise this year. Fathom, however, foresees both weaker inflation and growth than the Bank, essentially ruling out any rate hikes this year.

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Last year, Fathom highlighted to clients that stocks were overvalued by as much as 40%. With this in mind, it is unsurprising that equity markets saw such a tumultuous start to the month. The trigger appears to have been better-than-expected US payrolls data which reported that hourly earnings increased by 2.9% in the twelve months to January. Markets interpreted this as a forewarning of future inflation and a signal that the pace of Fed policy tightening could be faster than they previously expected.

Fathom’s view that equities are overvalued stems from our stylised formulation of the dividend discount model which suggests that equity prices are a function of the gap between real economic growth () and real risk-free rates (). Historical experience suggests that this  gap will eventually close — either due to increases in r or declines in g. Regardless of the cause of this narrowing, equity prices are likely to fall.

Whether or not this month’s events reflect the start of a prolonged market correction hinges upon how soon the  gap will narrow. This is one of many topics that Fathom will discuss with clients in this quarter’s Global Economic and Market’s Outlook.

Regardless of whether or not the gap closes, prolonged periods of asset overvaluation are often associated with heightened volatility, meaning that the market tranquillity of recent years could well be a thing of the past.

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For more charts on this subject and other current issues, clients of Thomson Reuters should visit the Hot Topics folders on Chartbook.

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