The US stock market had gone years without a correction, most likely because the zero-rate and quantitative easing policies of the Federal Reserve created a search for yield environment and potentially tempted many investors into excessive risk-taking. The catalyst for the correction, however, came from abroad. The China-induced global correction in stock markets around the world in August 2015 raises some key questions about where equities in the US might go next.
Our base scenario is that high levels of consumer confidence in the US and slow-growing corporate profits suggest a grinding and volatile market in the months ahead.Our base scenario is that high levels of consumer confidence in the US and slow-growing corporate profits suggest a grinding and volatile market in the months ahead. That is, China may have been the catalyst for the correction, but US stocks are likely to have their own dynamic going forward based on internal factors.
Up until August 2015, the equity markets and consumer confidence were both on a tear since hitting rock bottom in 2009. The S&P 500 rose over 200% from it’s March 2009 low, representing a compounded return of over 20% per year, on average (including dividends).
Likewise, the Conference Board Consumer Confidence Index, a diffusion index based on a scale of zero to 200, rose from its lowest levels ever in February and March 2009 (25.3 and 26.9, respectively), to a range of 90 to 104 during the past year. High consumer confidence might not, however, be great news for stocks for one simple reason: historically, it precedes the poor performance of equities. Moreover, if consumer confidence dips as a result of the recent turmoil in the equity markets, that isn’t necessarily a bad things for stocks going forward.
If one compares the level of the Conference Board index to the real return of the S&P 500 over the subsequent seven years, one fnds a reasonably tight relationship. (The real return of the S&P 500 = price return + dividends – inflation).
When consumer confidence was extremely high at the end of the 1960s, in the late 1990s/early 2000s, equity markets performed poorly during the subsequent seven year periods. By contrast, consumer confidence was extremely low during the early 1980s, early 1990s, and in 2009-2011. All of these periods were followed by spectacular gains in equity markets (Figure 1).
The Conference Board Consumer Confidence Index is currently slightly above its historical average since the index was created in 1968. This might suggest fairly average or somewhat below average returns for equities going forward. Historically, when consumer confidence has been close to current levels (around 101.5 on the Conference Board index), real equity returns during the next seven years have averaged around 20% in total – or around 3% per year (Figure 2). That’s not great and it’s a big comedown from the 20%+ annualized real returns that equity investors have enjoyed since 2009.
That said, there is an enormous amount of uncertainty. In its 47-year history, when the Conference Board index has been around its current level of 100, equity returns have ranged from -45% at the low end to nearly +100%. Thus, while a 20% gain by the summer of 2022 might be a reasonable estimate of the center of a distribution, the historical range outcomes around that central tendancy are extremely wide and the actual outcome could, of course, fall outside of even this seemingly wide range.
If Conference Board consumer confidence drops to say 90, as a result of the recent market turmoil, this would imply a somewhat better than expected real return for equities of about 60% over the course of the next seven years, or about 7% return per year. This is still below the S&P 500’s long-term average.
Further gains in consumer confidence, though perhaps encouraging in the very short term might not bode well for equity investors in the long term. Historically, when the Conference Board index gets to around 110, the average seven-year return of the equity market tends to get close to zero in real terms. Here, too, the relationship is not deterministic. With a Conference Board index reading of 110, the range of historical outcomes has been from -40% (1972 to 1979) to +80% (1983 to 1990). It’s not until the index gets up to the 120-140 area that the historical returns skew sharply negative. On the flip side, returns historically have been strongly positive when the index gets down to 60 or below (Figure 2).
If the pace of the rise in the equity markets does in fact slow substantially, it also implies structurally higher volatility. Sharp spikes in volatility like those that we have witnessed during the past few weeks will likely occur with greater frequency than they did during the nearly four years from September 2011 to July 2015, which passed without any major market corrections. Stocks are likely to be more volatile and more prone to sharp corrections if, hypothetically, they are rising at 3% per year on average than if they are rising at 20%+ per year. Volatility and returns tend to be inversely correlated.
Another concern is corporate profits. Profits have risen to significantly high levels in the past few years, but amid a tightening labor market and slow productivity growth, they appear to have hit a wall. After the crisis, corporate profits rebounded from around 5% of GDP to around 10% (Figure 3). The problem is that they have never really been able to exceed 10% of GDP historically. Moreover, they have been declining recently from 10% to 9.2% of GDP and may be in the process of falling further.
Given the still high level of corporate profits, the best that the equity market can likely hope for is that they grow in line with nominal GDP (real GDP + inflation). This could make for some slow profit growth since real GDP will expand by (optimistically) 2.5-3.0% over the next few years, and inflation is not likely to exceed 2%, if it even gets that high. As such, the most one can hope for in terms of profit growth is probably not more than 5% per annum for the next several years.
As noted though, 5% profit growth would be very optimistic. It’s quite possible that profits will grow more slowly than nominal GDP as they did once we passed the mid-point of the 1990s expansion, and as they did again around 2006 when they began declining in advance of the financial crisis. Curiously, in both cases, even as corporate profits began to fall, equities (and consumer confidence) continued to rise for a while (1997 to 2000 and 2006 to October 2007) until the day they didn’t. What did occur to both of these late-stage bull markets (1997-2000 and 2006-2007) was that equities began to advance in an increasingly volatile fashion as corporate profits fell. The VIX index rose substantially in 1997 and remained high in 1998 and 1999 even though equities didn’t top out until 2000. Likewise, the VIX began to rise again in 2006 as corporate profits began their decline, well in advance of the October 2007 peak. This reinforces the notion that even if equity market returns remain positive, the market could be much more volatile with, say, 3-7% average gains than it has experienced with the recent 20%+ gains.
In short, we don’t think that the equity bull market is necessarily over. It could continue for a while, even if corporate profits start to fall and even if consumer confidence continues to rise. That said, if the bull market continues, it will likely enter into a new phase, one with more interruptions like the ones that occurred in October 1997, August 1998, February 2007, and August 2015. It is less and less likely that it will resemble the smooth ascension, with occasionally soft landings, that we experienced between September 2011 and July 2015.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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