A new study from Research Affiliates finds U.S. equities “currently overvalued but not as much as suggested by the historical averages.” Contrarian investors are advised to take macroeconomic volatility into account:
Over the last two decades, US equity market price increases have pushed [earnings] yields to remarkably low levels, leading investors to wonder, what is fair value? Our analysis suggests that macroeconomic volatility can provide meaningful guidance to investors in recognizing fair value. Currently, we find that US equity market prices are still higher than their implied value, which is based on recent low levels of macroeconomic volatility. We believe the trend toward lower macro-vol and the higher valuations it justifies is waning. Therefore, long-term investors can benefit by considering the future trajectory of economic management, both in the US and abroad, and successfully advance their progress in the quest for the Holy Grail of fair value.
The challenge, of course, is to predict macroeconomic volatility.
Alternatively, investors might incorporate macroeconomic data into trend-following strategies. A simple model utilizing the headline unemployment rate is presented below. As noted, the most dangerous bear markets have occurred when the economy is also weakening. This observation is particularly important today with headline unemployment of 4.5% testing the low reaches of its historic range. Disciplined investors can acknowledge the potential for economic recession without fighting the current bull market.
We all know that the market leads the economy. But macroeconomic variables can inform market analysis. Contrarian and trend-following disciplines are both valid. As in most things financial, the “Holy Grail” probably lies somewhere in between.