- High valuations lead to large stock market declines during recessions.
- During secular bull markets, modest overvaluation does not produce large stock market declines.
- During secular bear markets, modest overvaluation still produces large stock market declines.
Using shorter term time frames, what matters more to stock prices is macro-economic and earnings momentum. Macro Man recently created a simple model that regressed retail sales, industrial production and durable goods, ex-transportation, to the stock market. The fit is remarkably good.
This got Macro Man to thinking. Retail sales, like the SPX, are very comfortably above pre-crisis highs, IP is marginally so, and orders are basically at the level. What would happen if we regressed these 3 series against the SPX? The results are set out in the chart below.
To mitigate the impact of leverage, Macro Man ran the same regression, but on the natural log of the SPX to smooth the swings in stocks relative to the economy. Upon obtaining model output, it was a trivial matter to reconvert the data back into SPX terms. The results of this study are below.
