Essay 4S:


Checking Up on the Health of the US Stock Market

Using Economic and Financial Indicators to Identify Good Years to Own Equities

Edward Renshaw
Professor of Economics
State University of New York at Albany

There is an old saying that prediction is very difficult, especially when it pertains to the future. There are times, however, when an investor in common stocks might be able to sleep more comfortably by keeping a wary eye on economic and financial indicators with a long history of being able to identify good years to have been in the market. In Table 4.1S we up-date a set of indicators that "would have worked well" from 1942-1989 and have (so far) continued to track the performance of the S&P composite stock price index rather well in the 1990s.

The nice thing about these indicators is that you don't need a computer or stock market guru to interpret their predictions. At the one year horizon, it is only the more extreme values of stock and bond market indicators that seem to be of much forecasting value (Renshaw 1993).

Some Deflation Indicators

The best years to have owned common stock since the crash of 1929 have been years containing a recessionary trough in economic activity as defined by the National Bureau of Economic Research. See Table 1.1S.

Economic recessions also have the distinction of being the only sure cure for inflation. Since the beginning of World War II there have been nine years when the Dec.-Dec. growth rate for the all item CPI was at least 1.4 percentage points less than the year-to-year increase in the CPI inflation rate. The following year financial returns for the S&P index have ranged from a low of only 5.4 percent in 1948 to a high of 31.0 percent in 1955 and have an average value of 20.4 percent. See Table 4.1S.

It should be noted, however, that some much needed stability has been imparted to the home ownership component of the CPI cost of shelter index as a result of a 1983 shift to a rental equivalent measure of home owner costs. The old procedure was to measure the price of new houses, mortgage interest rates and other cost elements that are borne by those relatively few families that are fortunate enough to be able to afford a new home during the month in question. This made the cost of home ownership very sensitive to changes in monetary policy. Since the change over to a rental equivalent value for the home ownership component we have not had any declines in the CPI inflation rate that were steep enough to trigger a good year signal for the S&P index.

The demise of CPI inflation signals may also be related to a more aggressive effort on the part of the Fed to prevent inflation from getting out of hand. Beryl Sprinkel, who was Chairman of the President's Council of Economic Advisers from 1985-89, was among the first economists to publicize a positive relationship between changes in the money supply and changes in stock prices. Since the beginning of World War II the financial returns for the S&P stock price index have always been positive during any year when M1 expressed in constant dollars was allowed to increase by 1.6 percent or more (Table 11.1S). The financial returns in the following year have also been positive if the growth rate for real M1 was allowed to accelerate by four percentage points or more--as has sometimes been the case during severe recessions and periods of slow economic growth when the inflation rate was declining.

Unemployment and the Financial Returns from Common Stock

Evidence in support of a non random pattern to stock prices is easy to overlook because it usually involves first or second differences in a statistical indicator. The validity of this conclusion can be illustrated by examining large changes in the unemployment rate. There have been seven years since the end of World War II when the unemployment rate increased by 1.4 percentage points or more and each of these recessionary years was followed by a positive return for the S&P index. There have been nine years since 1940 when the unemployment rate declined by one percentage point or more and each of these rather vigorous years of recovery from a recession inspired enough investor confidence to be followed by a positive return for the S&P index.

Taking Advantage of Stock Market Crashes in the Midst of Prosperity

The stock market is classified as being a leading economic indicator. In the post World War II period economic recessions have been of such short duration that by the time the Commerce Department's index of leading economic indicators declined by 2.2 percent or more, on a Dec.-Dec. basis, it was time to start looking for bargains in the stock market. Vigorous recoveries in the index of leading economic indicators amounting to six per or more have also inspired enough investment enthusiasm to push the S&P index higher in the following year (Table 7.5S).

While crashes in the midst of prosperity have tarnished the image of stock prices as a recessionary indicator, they will sometimes enable investors to acquire equities at bargain prices. Those years when the index of leading economic indicators increased and the average monthly value for the S&P index was down at least 1.6 percent from its preceding cyclical monthly high have (so far) always been followed by a positive financial return for the S&P index.

This degree of stock market "downness", when other indicators are signaling the continuation of a business expansion, deserves special mention since at the end of 1994 (when the S&P closed at 459.27) it was the only indicator in Table 4.1S that was signaling a good year to own common stock during 1995. There have been two other years when this type of divergence was a lone indicator pointing in the direction of a good year. Both of these years (1964 and 1987) were followed by double digit returns for the S&P index. They may help to explain why the S&P index, after closing out 1994 down 4.7 percent from its February 2 high of 482.00 quickly rebounded to a new historic high on Feb. 14, 1995.

There is another type of general purpose stock market indicator that is sometimes useful in helping one to benefit from stock market crashes in the midst of prosperity. Since 1941 the S&P index has always registered a positive return after any year when its average dividend yield increased by 24 basis points or more. An increase in the dividend yield of this magnitude can be caused by an increase in dividends and/or a decline in stock prices.

Dividend growth rates are adversely affected by economic recessions. Since the beginning of World War II economic recessions have been of such short duration that investors could have always anticipated a positive return for the S&P index after any decline in the dividend growth rate for the S&P index amounting to 3.2 percentage points or more (Table 4.2S). The financial returns for the S&P index have also been positive after any year when its associated earnings declined by at least six percent.

Taking Advantage of Downside Reversion in the S&P's High/Low Ratios

In recent years analysts have begun to appreciate that the financial returns associated with the S&P index have either varied too much or too little on a year-to-year basis to be consistent with a random walk. The implication is that stock returns may be subject to the phenomenon of "mean reversion" or a tendency for stocks that have enjoyed high (low) returns to exhibit lower (higher) returns in the future.

One of the more interesting ways to try to take advantage of this phenomenon is to compute the annual high/low ratios for the S&P index and purchase stocks after there has been a downside reversal for this ratio ( Table 4.3S). Since 1941 the following year financial returns for the S&P index have (so far) always been positive after a downside reversal. Why this signal should work so well is speculative. The extensive overlap of high/low ratio reversal signals in Table 4.1S with other good year indicators, however, should help to bolster one's confidence in this signal.

For the 40 years when one or more of the indicators in Table 4.1S were pointing in the direction of a good year to own stock the average financial return has been equal to 19.3 percent. This can be compared to an average loss of five percent, for the 13 years identified by a hatch mark in the last column of Table 4.1S, when none of the indicators were signaling a good time to own stock. It should be noted, however, that the S&P index is more richly valued now in terms of dividends received, than was the case from 1942-83, and that good year returns of less than ten percent have been occurring more frequently than was formerly the case.

It should also be emphasized that systems for identifying the best times to be in the stock market often break down and fail to explain the future as well as the past. The stock market indicators in Table 4.1S were identified by the author in the 1980s and eventually published in The Practical Forecasters' Almanac. They are easy to update using information in the yellow pages or cyclical indicator section of the Survey of Current Business and Standard and Poor's Security Price Index Record.

The signals, which are identified in the footnotes to Table 4.1S, have provided a more reliable indication of what has happened to the market (so far) in the 1990s, I believe, than most of the tips from market-timing advisers--which have a "spotty record" for recent years (Damato 1994). If you are going to play the stock market game, it is nice to at least have a score card and make some effort to understand how this market has behaved in relation to economic and financial indicators that are often publicized by the news media upon release by government agencies.

References

Damato, Karen (1994). "Market-Timing Advisers Have Spotty Record for Recent Years," The Wall Street Journal, April 28, C1 and C7.

Renshaw, Edward (1992), Editor. The Practical Forecasters' Almanac(Irwin Professional Publishing).

-----, (1993). "Modeling the Stock Market for Forecasting Purposes," Journal of Portfolio Management, 20(Fall), 76-81.


Table 4.1S

A Score Card for Some "Perfect" Predictors of Good Years to Have Been in the Stock Market.


Year    (1)    (2)    (3)    (4)    (5)    (6)    (7)  Following Year
                                                           Return

1941                   U             D     HLR              19.2
1942    CPI     M      U             D             E        25.7
1943    CPI            U                   HLR     E        19.3
1944-----------------------------------------------------   35.7#
1945-----------------------------------------------------  - 7.8#
1946                   U                                     5.5
1947    CPI     M                    D     HLR               5.4
1948    CPI                   L      D                      17.8
1949            M      U             D                      30.5

1950                          L            HLR              23.4
1951    CPI            U      L      D             E        17.7
1952-----------------------------------------------------  - 1.2#
1953                          L                             51.2
1954    CPI            U      L                             31.0
1955                   U                   HLR               6.4
1956-----------------------------------------------------  -10.4#
1957                          L      D                      42.4
1958            M      U      L      D             E        11.8
1959                   U                   HLR                .3

1960                          L      D                      26.6
1961-----------------------------------------------------  - 8.8#
1962                   U      L      D                      22.5
1963                                       HLR              16.3
1964                          L                             12.3
1965-----------------------------------------------------  -10.0#
1966                          L      D                      23.7
1967            M                    D     HLR              10.8
1968-----------------------------------------------------  - 8.3#
1969                          L            HLR               3.5

1970                   U             D             E        14.1
1971                          L            HLR              18.7
1972-----------------------------------------------------  -14.5#
1973-----------------------------------------------------  -26.0#
1974                          L      D                      36.9
1975    CPI     M      U      L      D     HLR     E        23.6
1976-----------------------------------------------------  - 7.2#
1977                          L      D                       6.4
1978                   U      L      D                      18.4
1979                          L            HLR              31.5


Table 4.1S (continued). A Score Card for Some "Perfect" Predictors of Good Years to Have Been in the Stock Market.


Year    (1)    (2)    (3)    (4)    (5)    (6)    (7)  Following Year
                                                           Return

1980-----------------------------------------------------  - 4.8#
1981    CPI                   L            HLR              20.4
1982    CPI     M      U             D             E        22.3
1983                          L            HLR               6.0
1984                   U             D                      31.1
1985            M                                  E        18.5
1986            M                          HLR               5.7
1987                          L                             16.3
1988                          L      D     HLR              31.2
1989-----------------------------------------------------  - 3.1#

1990                          L      D     HLR     E        30.0
1991            M                    D             E         7.4
1992            M                          HLR               9.9
1993-----------------------------------------------------    1.3# 
1994                          L                                ?        

Footnotes for Table 4.1S

CPI represents years when the Dec.-to-Dec. growth rate for the CPI was at least 1.4 percentage points less than the year-to-year growth rate for the CPI.

M represents years when the first differences in the Dec.-to-Dec. growth rates for the real money supply are equal to four percentage points.

U represents years when the unemployment rate either increased by 1.4 percentage points or declined by at least one percentage point.

L represents years when the revised index of leading economic indicators increased at least 6 percent, declined by at least 2.2 percent or was positive when the December down ratio for the S&P index was less than .984.

D represents years when the dividend growth rate for the S&P index declined at least 3.2 percentage points or when the average dividend yield increased by at least 24 basis points.

HLR represents years when there was a downside reversal for the yearly high- low ratio for the S&P index.

E represents years when the earnings for the S&P index declined by at least six percent.

# identifies financial returns following years with no good year signals.

Source: The Practical Forecasters' Almanac(Irwin Professional Publishing, 1992), Table 2.91. Some of the signals for the Commerce Department's index of leading economic indicators have been adjusted to conform with changes in the index discussed in the October 1993 issue of the Survey of Current Business (SCB). The data needed to update this Table can be obtained from the cyclical indicator section of the SCB and S&P's Security Price Index Record.


Table 4.2S

The Earnings, Dividends and Financial Returns Associated with the S&P Stock Price Index.


Year   Earnings   Dividends   Payout   % Change   Difference   Financial
            (dollars)         Ratio    Dividends   % Points      Return   
               
          (1)       (2)        (3)        (4)         (5)         (6)

1942     1.03       .59       57.3      -16.9@      -22.9        19.2
1943      .94       .61       64.9#       3.4        20.3        25.7*
1944      .93       .64       68.8#       4.9         1.5        19.3
1945      .96       .66       68.8        3.1       - 1.8        35.7
1946     1.06       .71       67.0        7.6         4.5       - 7.8
1947     1.61       .84       52.2       18.3        10.7         5.5
1948     2.29       .93       40.6       10.7       - 7.6         5.4
1949     2.32      1.14       49.1#      22.6        11.9        17.8*

1950     2.84      1.47       51.8#      28.9         6.3        30.5
1951     2.44      1.41       57.8#     - 4.1@      -33.0        23.4
1952     2.40      1.41       58.8         .0         4.1        17.7*
1953     2.51      1.45       57.8        2.8         2.8       - 1.2
1954     2.77      1.54       55.6        6.2         3.4        51.2
1955     3.62      1.64       45.3        6.5          .3        31.0
1956     3.41      1.74       51.0#       6.1       -  .4         6.4
1957     3.37      1.79       53.1        2.9       - 3.2       -10.4
1958     2.89      1.75       60.6#     - 2.2@      - 5.1        42.4*
1959     3.39      1.83       54.0        4.6         6.8        11.8*

1960     3.27      1.95       59.6#       6.6         2.0          .3
1961     3.19      2.02       63.3#       3.6       - 3.0        26.6
1962     3.67      2.13       58.0        5.4         1.8       - 8.8
1963     4.02      2.28       56.7        7.0         1.6        22.5
1964     4.55      2.50       54.9        9.6         2.6        16.3
1965     5.19      2.72       52.4        8.8       -  .8        12.3
1966     5.55      2.87       51.7        5.5       - 3.3       -10.0
1967     5.33      2.92       54.8#       1.7       - 3.8        23.7*
1968     5.76      3.07       53.3        5.1         3.4        10.8*
1969     5.78      3.16       54.7        2.9       - 2.2       - 8.3

1970     5.13      3.14       61.2#     -  .6@      - 3.5         3.5
1971     5.70      3.07       53.9      - 2.2@      - 1.6        14.1*
1972     6.42      3.15       49.1        2.6         4.8        18.7
1973     8.16      3.38       41.4        7.3         4.7       -14.5
1974     8.89      3.60       40.5        6.5       -  .8       -26.0
1975     7.96      3.68       46.2#       2.2       - 4.3        36.9
1976     9.91      4.05       40.9       10.1         7.9        23.6*
1977    10.89      4.67       42.9       15.3         5.2       - 7.2
1978    12.33      5.07       41.1        8.6       - 6.7         6.4
1979    14.86      5.65       38.0       11.4         2.8        18.4*  


Table 4.2S (continued). The Earnings, Dividends and Financial Returns Associated with the S&P Stock Price Index


Year   Earnings   Dividends   Payout   % Change   Difference   Financial
            (dollars)         Ratio    Dividends    % Points     Return   
               
          (1)       (2)        (3)        (4)         (5)n        (6)

1980    14.82      6.16       41.6#       9.0       - 2.4        31.5
1981    15.36      6.63       43.2        7.6       - 1.4       - 4.8
1982    12.64      6.87       54.4#       3.6       - 4.0        20.4
1983    14.03      7.10       50.6        3.3       -  .3        22.3*
1984    16.64      7.53       45.3        6.1         2.8         6.0
1985    14.61      7.90       47.6#       4.9       - 1.2        31.1
1986    14.48      8.28       57.2#       4.8       -  .1        18.5
1987    17.50      8.81       50.3        6.4         1.6         5.7
1988    23.76      9.73       41.0       10.4         4.0        16.3
1989    22.87     11.05       48.3#      13.6         3.2        31.2
1990    21.34     12.10       56.7#       9.5       - 4.1       - 3.1
1991    15.97     12.20       76.4#        .8       - 8.7        30.0*
1992    19.09     12.38       64.9        1.5          .7         7.4*
1993    21.88     12.58       57.5        1.6          .1         9.9
1994    30.63     13.18       43.0        4.8         3.2         1.3

(5)n. The first differences in the growth rates for dividends in column (4).

#Years when the payout ratio increased by 2.3 percentage points or more. The financial returns in these years have usually been positive.

@Years when the dividend growth rate was negative. The financial returns in these years and the following year have been positive.

*Financial returns following negative differences in column (5) of 3.2 percentage points or more.

Source of basic data: Standard and Poor's Security Price Index Record.


Table 4.3S

Stock Market Volatility and the Financial Returns Associated with the S&P Index.


       Values for the S&P Index
Year   ------------------------    High-Low    Financial
         High     Low     Close      Ratio       Return
         (1)      (2)      (3)        (4)         (5)
1928    24.35    16.95    24.35      1.437       41.9
1929    31.92    17.66    21.45      1.807      - 7.9
1930    25.92    14.44    15.34      1.795      -23.9
1931    18.17     7.72     8.12      2.354      -41.7*
1932     9.31     4.40     6.89      2.116      - 9.0
1933    12.20     5.53    10.10      2.206       53.0*
1934    11.82     8.36     9.50      1.414      - 1.5
1935    13.46     8.06    13.43      1.670       46.3*
1936    17.69    13.40    17.18      1.320       33.3
1937    18.68    10.17    10.55      1.837      -33.9*
1938    13.79     8.50    13.21      1.622       30.0
1939    13.23    10.18    12.49      1.300      -  .8*
1940    12.77     8.99    10.58      1.420      - 9.9
1941    10.86     8.37     8.69      1.297      -11.2
1942     9.77     7.47     9.77      1.308       19.2*
1943    12.64     9.84    11.67      1.285       25.7
1944    13.29    11.56    13.28      1.150       19.3*
1945    17.68    13.21    17.36      1.338       35.7
1946    19.25    14.12    15.30      1.363      - 7.8
1947    16.20    13.71    15.30      1.182        5.5
1948    17.06    13.84    15.20      1.233        5.4*
1949    16.79    13.55    16.76      1.239       17.8
1950    20.43    16.65    20.41      1.227       30.5
1951    23.85    20.69    23.77      1.153       23.4*
1952    26.59    23.09    26.57      1.152       17.7
1953    26.66    22.71    24.81      1.174      - 1.2
1954    35.98    24.80    35.98      1.451       51.2
1955    46.41    34.58    45.48      1.342       31.0
1956    49.74    43.11    46.67      1.154        6.4*
1957    49.13    38.98    39.99      1.260      -10.4
1958    55.21    40.33    55.21      1.369       42.4
1959    60.71    53.58    59.89      1.133       11.8
1960    60.39    52.30    58.11      1.155         .3*
1961    72.64    57.57    71.55      1.262       26.6
1962    71.13    52.32    63.10      1.360      - 8.8
1963    75.02    62.69    75.02      1.197       22.5
1964    86.28    75.43    84.75      1.144       16.3*
1965    92.63    81.60    92.43      1.135       12.3
1966    94.06    73.20    80.33      1.285      -10.0
1967    97.59    80.38    96.47      1.214       23.7
1968   108.37    87.72   103.86      1.235       10.8*
1969   106.16    89.20    92.06      1.190      - 8.3
1970    93.46    69.29    92.15      1.349        3.5*


Table 4.3S (continued). Stock Market Volatility and the Financial Returns Associated with the S&P Index


       Values for the S&P Index
Year   ------------------------    High-Low    Financial
         High     Low     Close      Ratio       Return
         (1)      (2)      (3)        (4)         (5)
1971   104.77    90.16   102.09      1.162       14.1
1972   119.12   101.67   118.05      1.172       18.7*
1973   120.24    92.16    92.55      1.305      -14.5
1974    99.80    62.28    68.56      1.602      -26.0
1975    95.61    70.04    90.19      1.365       36.9
1976   107.83    90.90   107.46      1.186       23.6*
1977   107.00    90.71    95.10      1.180      - 7.2
1978   106.99    86.90    96.11      1.231        6.4
1979   111.27    96.13   107.94      1.157       18.4
1980   140.52    98.22   135.76      1.431       31.5*
1981   138.12   112.77   122.55      1.225      - 4.8
1982   143.02   102.42   140.64      1.396       20.4*
1983   172.65   138.34   164.93      1.248       22.3
1984   170.41   147.82   167.24      1.153        6.0*
1985   212.02   163.68   211.28      1.295       31.1
1986   254.00   203.49   242.17      1.248       18.5
1987   336.77   223.92   247.08      1.504        5.7*
1988   283.66   242.63   277.72      1.169       16.3
1989   359.80   275.31   353.40      1.307       31.2*
1990   368.95   295.46   330.22      1.249      - 3.1
1991   417.09   311.49   417.09      1.339       30.0*
1992   441.28   394.50   435.71      1.119        7.4
1993   470.54   429.05   466.45      1.097        9.9*
1994   482.00   438.92   459.27      1.098        1.3

*Financial return following a downside reversal for the yearly high-low ratio in column (4).

Source of basic data: Standard and Poor's Securities Price Index Record.


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