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.