When do equities do well?

In past articles we have written on the strong mean reverting properties of equity returns.

We have shown that equity markets historically experience large periods of time where the multiple on future earnings contracts or increases. These "market" cycles often last 15 - 17 years. We are currently 11 years into a declining multiple market cycle.

During such a period we find that equity markets are particularly sensitive to macro news. Indeed, in a period of a declining price/earning ratio, the market is extremely senstive to a macro economic indicator such as the PMI. This is because in such a period fundementals are not as important in investing as awareness of how the macro environment is evolving. As a result, during this period of the market cycle, buy and hold is not as an effective investment strategy. One needs to re balance the portfolio with greater frequency.

The best environment for the stock market would be if there was low inflation and increasing earnings overall(economic growth).

If there is an anticipation of strong future inflation, then each dollar of future profit will be worth less, as each dollar will buy less. As a result investors will pay less for future profits, hence the price-earning ratio will decrease. The fear of inflation (a macroeconomic feature) can therefore lead to price/earning ratios decreasing. During such periods of time it is therefore no surprise that the equity markets are very sensitive to the PMI index. We can see below this was the case during the 1970s, when inflation was a problem for the US economy. A similar trend is now occuring.


Furthermore, when bond yields start becoming much larger than the dividend yield, it is another indication the market is anticipating inflation.

Deflation would also be bad for equity markets. However, this would not affect the multiple. Future dollars of profits would in fact be worth more and the multiple in theory could even increase. The problem is that earnings for the economy in general will suffer. Hence the same multiple on a lower earning leads to a lower stock price.

The fear of inflation and the extreme valuation reached in 2000 have been vital contributors to the declining price-earning ratio the equity markets have suffered during the last 11 years. What is a surprise is how well bonds have performed during this period, as yields have continued to compress due to government distortions in this market - which is probably the largest contributor to the markets inflationary fears.