Rising Stock Market Optimism Amid Economic Uncertainty

Rising Stock Market Optimism Amid Economic Uncertainty 

The latest consumer survey data from the New York Federal Reserve provided intriguing insights.

According to the New York Fed, expectations that stock prices will rise in the next 12 months increased from 39% to 41% compared to the previous month. Meanwhile, inflation expectations slightly declined. Recent consumer sentiment data highlights the disparity between demographics, with some groups prospering more than others. Given the market's proximity to all-time highs, it's not surprising that stockholders feel optimistic.

Yahoo Finance suggests that this bullish sentiment underscores the "haves and have-nots," a viewpoint supported by the fact that the wealthiest 10% of households own 85% of equities.

However, survey data indicates that rising stock prices have boosted confidence across various age and income groups. This is expected, considering the constant media coverage of the current bullish market.

Notably, confidence has surged the most among the lower and middle-income brackets. The rise of trading apps like Robinhood and extensive social media commentary have likely encouraged these groups to join the market, hoping for quick gains.

Despite the growing bullish sentiment, caution is warranted.

Understanding Capital Gains Capital gains depend on market capitalization, nominal economic growth, and dividend yield. Using John Hussman's formula, we can predict returns over the next decade as follows:

(1+nominal GDP growth)×(normal market cap to GDP ratioactual market cap to GDP ratio)110−1(1 + \text{nominal GDP growth}) \times \left(\frac{\text{normal market cap to GDP ratio}}{\text{actual market cap to GDP ratio}}\right)^{\frac{1}{10}} - 1(1+nominal GDP growth)×(actual market cap to GDP rationormal market cap to GDP ratio)101−1

Assuming a 2% annual GDP growth, a stable market cap/GDP ratio of 2.0, and a 2% dividend yield, the forward returns would be:

(1.02)×(1.21.5)110−1+0.02=−1.08%(1.02) \times \left(\frac{1.2}{1.5}\right)^{\frac{1}{10}} - 1 + 0.02 = -1.08\%(1.02)×(1.51.2)101−1+0.02=−1.08%

This scenario relies on several optimistic assumptions, including achieving the Fed's 2% inflation target, lowering current interest rates, and avoiding a recession.

Despite these critical factors, retail investors are showing renewed optimism. Household equity ownership is near record levels, historically signaling market peaks.

If economic growth falters, reduced valuations could be damaging, as seen at previous market peaks when expectations outpaced economic realities.

Bob Farrell famously noted that investors buy the most at market tops and the least at bottoms, reflecting long-term investor behavior. Our colleague Jim Colquitt highlighted this with data showing a strong correlation between average investor equity allocations and S&P 500 future 10-year returns, supporting Farrell's Rule #5. The inverted 10-year forward returns suggest a reversion toward zero from current high equity allocations.

Investor sentiment often peaks at extremes of optimism or pessimism, leading to reversals. Sam Stovall of Standard & Poor's noted:

"If everybody's optimistic, who is left to buy? If everybody's pessimistic, who's left to sell?"

The challenge lies in predicting what will eventually reverse this psychology.

Exuberance vs. Reality It's not surprising that equity markets are currently rising, especially with expectations of nearly 20% annual earnings growth over the next 18 months. Massive corporate share buyback programs have also boosted stock prices and earnings per share by reducing the number of shares outstanding.

However, as economic growth slows and disinflation affects earnings, profit margins will contract. Profit margins are closely linked to economic activity.

"Profit margins are probably the most mean-reverting series in finance. If they don't revert, it suggests a problem with capitalism. High profits should attract competition; if not, the system isn't functioning properly." – Jeremy Grantham

Historically, markets trading well above actual profits have eventually realigned with economic realities.

Several risks could affect the market in the coming months, particularly if economic growth slows and unemployment rises.

While the consumer survey shows strong bullish sentiment for continued asset price increases, this optimism hinges on the belief that the Fed can manage the situation. History suggests there's a significant chance they might not.