Prosperity

The US Economy is doing very well, but what does that mean for US equities?

In the 1970s, economist Arthur Okun created the “Misery Index,” which he computed by adding the inflation rate to the unemployment rate.

 Our friend Russell Pennoyer has proposed a new measure of macro-economic health that he calls the “Prosperity Index.” The Prosperity Index is computed by subtracting the unemployment rate from the rate of GDP growth. Therefore, prosperity is maximized when GDP growth is high and unemployment is low. The logic of combining these two metrics into a single index is that GDP growth alone may miss the key role that employment plays in an economy driven by consumer spending. We show this index below from 1948 to the present.

Figure 1: The Prosperity Index

Source: FRED

For the last 30 years, the index has averaged -3.4% (the unemployment rate usually exceeds the GDP growth rate). But the three-year rolling average recently reached -1.6% in the third quarter of 2019, marking the highest reading since 2000 and, before that, the economic boom of the 1960s. We are living through a period of great economic prosperity.

But there’s a curious thing about economic prosperity: it happens to be negatively correlated with future stock returns. Everyone who's read a sell-side market commentary deck or journalistic commentary on today's market movements knows how much they love to read the GDP and unemployment tea leaves. But the evidence suggests that these economic indicators predict exactly the opposite of what most people think. Below we show the Prosperity Index relative to one-year forward returns on the S&P 500 and on the Fama-French small-cap value index.

Figure 2: Stock Returns vs. the Prosperity Index by Quartile 1948–2018

Source: Ken French data library, Capital IQ, FRED

Other researchers have identified the same negative relationship in analyzing GDP and unemployment separately. GDP growth has a negative correlation with stock prices, an MSCI Barra study found, because “if expectation of future GDP growth is entirely built into today’s valuations, stock price movements will tend to precede developments in the underlying economy.” And unemployment levels have historically had an inverse relationship with valuations (as defined by Robert Shiller’s cyclically-adjusted price-to-earnings ratio or CAPE): the lower the unemployment rate, the higher the valuations as investors project today’s confidence into the future.

Figure 3: Unemployment Rates and CAPE Ratios vs. 5-Year Forward Returns by Quintile

Source: Seeking Alpha

What should investors do with this knowledge? We know we are living through an era of great prosperity. We know that economic prosperity tends to be correlated with low future stock returns. And we know that we can’t get in a time machine and rewind to 2009 or any other optimal time to buy equities.

The logical answer is to send our money abroad in search of economies not in such a good shape, where the economic conditions and stock market valuations look more like the US in January of 2010 than January of 2020.

Below, we show the 12 countries where the Prosperity Index is below -4.2% (equivalent to the fourth quartile of worst economic times in the United States), suggesting that these are the best times to buy stocks in general, and small-cap value in particular, in these countries.

Figure 4: The Prosperity Index by Country

Source: StarCapital, Trading Economics

The big thing that jumps out from this page is the dire economic state—and thus relative attractiveness of stocks—in Europe. Greece, Turkey, Spain, Italy, France, Austria, Sweden, and Portugal are all suffering economically. There are also pockets of opportunity in South Africa, Brazil, Hong Kong, and Canada, but Europe is the biggest opportunity.

These are heady times for the US economy and US investors. The US is the largest, strongest economy in the world, and its companies, from Apple to Amazon, seem unbeatable. But prudent investors know that the odds are better on the underdogs, and that prudence suggests a rather sizable international allocation might be the best course of action.