What’s Discussed
According to McKinsey & Company, the business sector is 72% of global GDP.[1] Therefore, the health of “the economy” is largely a function of the health of businesses. Another measure of the health of businesses is the stock market. Because of this linkage, economic data can be a powerful tool to understand stock market outcomes.
In this paper, we present a simple metric for the state of the global economy: the proportion of the economic indices which improved in the prior year. We call this the “Percentage Improving” or “PI.” We then make the following observations:
- The one-year performance of the global stock market is closely aligned with the PI.
- When the PI is below 45% and falling, it has been better on average to not invest in stocks.
The Percentage Improving (PI)
At Atlas Capital, we track more than three hundred economic indices. These indices represent the fourteen largest countries by GDP and all the major categories of economic information including employment, GDP growth, confidence, industrial production, consumption, housing, and financial conditions. We then calculate the proportion of the indices which improved over the prior twelve months (PI).
The green line on the chart shows the PI. When the PI is below 50%, the majority of economic indicators became weaker in the prior year. In most of the instances in which the PI fell below 30%, the US was in a recession.
The PI and the Stock Market
The following chart adds a blue line to the chart above, showing the one-year performance of global equities relative to cash. The close connection between the global economy and stock market outcomes is clear. Since 1968, the two lines have often been on top of one another. The turning points were the same as well.
Another way to look at the powerful relationship between the PI and stock market returns is to calculate the historical average stock market return as a function of the PI.[2] On average, global equities have had a better return than cash only when most economic indices improved, i.e., when the PI has been at 50% or higher.
When Equity Investors Should Worry
The most dangerous times to be invested in the stock market have been when the PI was low and falling. In the following chart, the shaded “Danger Periods” are when the PI was below 45% and the PI trend was down. This has happened 25% of the time. In those periods, the average return of global equities was 6.3% per year below the return of cash. In the non-shaded periods, the average return of global equities was 7.4% higher than cash.
Summary
The performance of the stock market is tightly linked to the performance of the global economy. Historically, the stock market has delivered a return well above cash if most economic indicators improved in the prior twelve months. On average, the global equity return was meaningfully below cash when the percentage of economic data improving (PI) was below 45% and falling.
The economic dataset is the most important component of the framework used by Atlas Capital Advisors to identify equity downside risk. Monthly updates of this information are provided by Atlas on our website at https://atlasca.com/core-concepts/markets-and-the-economy/.
[2] The PI buckets used for calculating the average shown on the chart are all values within 5% of the point. For instance, the 50% point is an average of all instances in which the PI was between 45% and 55%.
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