Core Concepts

Markets And The Economy

Academic research finds a recurring pattern in financial crises. Investors and borrowers tend to extrapolate, expecting the conditions of the recent past to continue. These dynamics lead to self-reinforcing uptrends in credit, investment markets, and the economy, causing the Value (the relationship of prices to fundamentals) of investment assets to deteriorate.

Market busts and financial crises arise when optimistic beliefs are disappointed. The usual source of disappointment is a downturn in economic growth. The headline description for most of the equity bear markets in US history is: “Stocks were expensive, and then there was a recession.”

Economic growth drives earnings growth, and earnings growth drives stock prices. As a consequence, changes in the economy and in stock prices are closely aligned. Atlas monitors the most important economic data from the largest economies in order to create a big-picture view of economic changes. The two lines on the chart below are the one-year change in global stock prices (in black) and the percentage of the global economic data which improved in the prior year (grey shading). It’s quite evident from the chart that equity price changes are tightly interlinked with economic changes.

At present there is somewhat of a disconnect, with stock market returns being above what would have been expected based on the economic data. Disconnects can happen when falling interest rates boost stock prices, as in 1987, but interest rates have mostly risen over the past year. The other type of disconnect occurs when equity investors anticipate an improvement in the economic data. Equity investors are sometimes correct about the outlook. For instance, the large disconnect during the COVID recession in 2020 resolved with the economic data catching up to equity returns. Equity investors are sometimes overoptimistic as well — in 1970, 1980, 1990 and 2007 the disconnect resolved with equity prices falling to align with the weak economic data.

Investors in equities are most vulnerable to sustained losses when stocks are expensive, and there is a recession. It is straightforward to observe expensiveness, but unfortunately, it is quite challenging to predict if a recession might happen in the next year. The metric which Atlas finds helpful for predicting US recessions is the proportion of global economic data, which is “bad and getting worse”. “Bad” means the data is below the median for the entire history of that data series. “Getting worse” means the latest data release is worse than the median for the prior year. In the last fifty years, whenever the proportion of data in the “bad getting worse” category rose over 50%, the US entered a recession, usually within a few months. Consequently, if Atlas observes that this metric is climbing toward 50%, particularly if several other items on our equity risk dashboard are negative, we will tend to advise clients to lower the equity risk in their portfolios. In August 2022, the proportion of economic indices we track which are in the “bad getting worse” category breached the 50% level. This would typically imply a recession was due. However, in this instance, the proportion “bad getting worse” fell back below 50% in February 2023. No recession has yet occurred in the US and some categories of economic information remain strong, such as employment. Global economic growth is sluggish, with 2024 real growth estimated at 1.5% for the US, 0.8% for Japan, and 0.7% for Western Europe.

Have a question for
Atlas Capital Advisors?

Our approach is based on research and unique to your wealth management needs. We have the experience for individuals or an institution.