HOW THE U.S. STOCK MARKET WORKS

Many investors either try to predict the stock market or assume that it is totally random. The stock market is, in fact, complex containing both systematic and random components. In the following, we show that the pattern of the U.S. stock market is cyclical because the economy is. A general equation of stock market behavior also describes the four major investment styles.

Most econometric studies have been able to explain only 45% of the variation in absolute stock returns, a level of explanation not useful for investment decision making. Econometrics, however, explains changes in the valuation ratio of bond prices relative to stock prices.

We have found that more than 95% of the variation in relative stock prices is explained by a model that states: future capacity utilization and inflation determine relative stock prices. Note that we have assumed a zero intercept.

 
 
 Bond Yields(t)
 ----------- = .022 * cap util(t+1) - .079 * infl(t+1)
 Stock Earnings Yields(t)
 
 where: Bond Yields are the long term AA utility rate.
 Stock Earnings Yields are trailing S&P 500 operating
 earnings divided by the current level of the S&P 500.
 

Utilizing thirty-two years of S&P 500 data for the years 1968-1999, we found that this model explains more than 95% of relative stock market variation.^* In the United States, the stock market double discounts expected inflation, first through long term bond yields and second through relative stock prices.

However, during the course of several business cycles, growth in the S&P 500's earnings will dominate the cyclical terms located on the right side of this model; hence the observation that stocks are a hedge against inflation. The crucial assumption in any financial discussion is the assumed time horizon of the investment.

Since expectations of cyclical economic changes determine changes in this valuation ratio, a useful short-term decision rule can be developed, within your asset allocation guidelines:

     1. Buy stocks when you expect inflation to remain low or to decrease.

     2. Sell stocks when you expect inflation to increase.  

The equation above also describes the four major styles of investing:

1. Value investors concentrate upon the left side of the equation, purchasing the stocks of low P/E companies in non-cyclical industries with the expectation that P/Es will improve with improving events. To these investors, decreases in the stock market create opportunities.

2. Sector rotators concentrate upon the right side of the equation, successively purchasing the stocks in various industries according to their determinations of how the economic cycle will evolve.

3. Growth investors concentrate upon companies with high earnings growth. To these investors, the behavior of the overall market is less relevant.

4. In forward looking financial markets, past stock price patterns should not predict future stock prices therefore technical analysis is a waste of time. The reason why some technical analysis works is that both capacity utilization and inflation are, to a point, statistically trending variables.

In general, value investing is less risky than growth investing. If you have not already done this, you should learn what investment style you are the most comfortable with.

* We also suggest reading "Is the Stock Market Rational?" that discusses exceptions to the rational model and “The Nature of Stock Market Equilibrium” that discusses why this Gaussian model is appropriate in a non-Gaussian world.

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