Markets are future-oriented, that is to say that investors make buying decisions in light of expectations. One buys if one expects the investment to go up in value in the future. One sells if one expects the opposite. We've found two market indicators that are particularly good at capturing expectations of U.S. growth and one which is particularly good at forecasting global growth.
First, the United States.
People like to treat the U.S. Stock market as an indicator of growth expectations, and that's not entirely illogical. Stocks are shares in a company's future earnings growth. If the expectations for growth go up, all other things being equal, it is logical to conclude that investors expect growth. But all other things are seldom equal. As stock prices and valuations are changing, so are bond valuations. Bonds are fixed income investments, meaning that unless the bond issuer defaults (breaks the promise to pay interest), the investor is guaranteed interest payments of a fixed amount. Since U.S. Treasuries are backed by the full faith and credit of the U.S., they are considered to be very safe, and so there's a lot of confidence that they will pay the amounts which they guaranteed contractually that they would.
So, stocks are a bigger chance than bonds and especially a bigger chance than treasuries. We created a formula which compares investors' preference for U.S. Treasury bonds over a broad-based U.S. stock index. It's called the Earnings Yield Premium (EYP for short). Sometimes it is called the Equity Risk Premium.
Here's a short overview from Investopedia:
Recall the three steps of calculating the risk premium:
1. Estimate the expected return on stocks
2. Estimate the expected return on risk-free bonds
3. Subtract the difference to get the equity risk premium.
Here's what it looks like over time:
You can see that it spiked before and during the great recession, during the European Debt Crisis and also during the recent pandemic crisis. But in more recent months, it has been dropping. That means expectations got much worse during the crisis but have gotten considerably better now. What if we rearranged the data from being in order of time to instead go in order of most optimistic to least optimistic along the bottom axis, and then compared that to subsequent GDP growth for the year after on the up-and-down axis? It would look like this:
It makes sense that the line slopes downward. That means there is a negative correlation between this fear metric and growth. When markets are showing more fear, growth tends to be slower after and vice versa. This means that although this combination of stock and treasury valuations doesn't forecast the economy perfectly, it does add some value. As of the end of Q2 2020, it was forecasting roughly 1% annual growth. Since then, the stock market has shifted towards even more optimism.