This morning’s release of Gross Domestic Product (GDP) – the standard measure of a nation’s economic activity – contains an important warning that equity market investors would do well by heeding.
The warning is not that equity markets are trading too rich vis-à-vis its long-term trend. Rather, the warning is that the real economic activity that should be reflected by capital markets have been signaling a severe slowdown that has already lasted for more than a decade and will be further exacerbated by COVID-19-related effects.
The obvious disconnect between Wall Street and Main Street apparent in the data is important to understand and very much relates to the concept of “paradigm shifts” that I talk about in my writing about climate change investing.
The graphic below shows the Bureau of Economic Analysis’s GDP data – plotted on a logarithmic scale – for the entire post-War period of modern markets.
This data series fluctuates only slightly around its dotted green trendline – even today’s -4.5% reading represents barely a blip. The real economy is much more resilient and stable than the quixotic forecasts of economic activity projected by participants in capital markets.
For this graph, it is easiest to think about high- and low-growth periods in terms of the slope of the data series’ line in relationship to the trendline.
When the blue series is moving further above the green trendline, the country’s GDP was experiencing above-trend growth; when the blue series is moving further below the green trendline, GDP was slowing below trend. When the blue line runs parallel to the trendline, whether above or below, it simply means that the economy was running roughly apace to trend, but at a higher or lower base rate due to the previous deviation from trend growth.
The particular fact to note from this GDP graph is the degree to which it has fallen further and further below the long-term trendline after the Financial Crisis (A). It might be surprising to see that the present GDP divergence from the long-term trend is the greatest in post-War history and the divergence is bound to become more extreme over the next few quarters due to COVID-19 slowdowns to domestic economic activity and to global trade.
Contrast this measure of real economic activity with a measure of publicly traded equity market values.
Dr. Robert Shiller of Yale meticulously reconstructed an estimate of historical equity market values, adjusted for inflation, reinvested dividends, and stock buybacks starting in the mid-19th century. The graphic below shows these data – again plotted on a logarithmic scale – for the entire post-war period of modern markets.
Similar to the GDP graph, when the gray line’s slope is significantly steeper than the trend line, we know we are seeing the statistical artifact of a bull or bear market. As such, on this graph, we can clearly see the post-War Boom (B), the Oil Shock-induced malaise of the 70s (C), the Tech Boom and Dot.Com Crash (D), and the Mortgage Crisis of 2008-2009 (E). Note that even though Professor Shiller’s most recent data ends in September 2019, the present market level is quite close to the historical trendline. From this, perspective, the market is “fairly valued.”
Combining the above two data series onto the same graph offers several interesting insights.
The most important insight is the relative slopes of the two data series after the Financial Crisis. Notice that the slope of the gray market line after the 2009 nadir is strongly positive, while the slope of the blue GDP line is much less so. These two lines seem to be forming into a wedge – with the increasing value of the market outpacing that of economic activity.
Another way of saying this is that the ratio of market value to GDP – reportedly one of Warren Buffett’s favorite gauges of relative market representation – is at an historic high. The St. Louis Federal Reserve’s FRED datastore tracks this ratio, which is now sitting at an eyewatering level, compared to historical values.
There is one important fact to realize when analyzing these data – namely, we are necessarily comparing apples to oranges.
GDP is a measure of all economic activity – both publicly-traded firms like IntelINTC and privately-owned ones like your local mom and pop eatery – whereas Professor Shiller’s data or data from Wilshire Associates necessarily covers only publicly-traded firms.
Roughly two-thirds of economic activity in the U.S. is associated with privately-owned firms, so market data reflects only the prospects of the one-third of economic activity represented by publicly traded firms.
To the extent, though, that publicly traded firms rely on domestic consumer demand to drive revenue growth and profitability, struggling private businesses and the lowered demand that necessarily stem from those struggles will negatively affect publicly traded firms as well.
The market is soaring today, perhaps due to the expectation that GDP has bottomed out in 1Q20, but from a longer term perspective, your correspondent is more concerned about the long-term mismatch between economic growth and market values that started over a decade ago is a Wile E. Coyote moment for investors.
The graphs above, in my view, portend a coming paradigm shift — a moment of cognitive dissonance that must eventually resolve, as moments of cognitive dissonance always do, in favor of truth.
While I believe this shift must take the form of one to a more sustainable, ecologically sensible paradigm, I understand that even positive paradigm shifts bring with them a great deal of pain and unintended consequences.