Top 10 Market and Economic Variables to Watch…and 3 to Ignore – Part I
At its core, investment management involves researching thousands of variables and data points. Careful analysis is required of all of these variables and data points to create a “mosaic of information” in order to draw a conclusion on market and economic directions. With the 24/7 news cycle, investors have more data, surveys and reports in front of them than ever before.
In the spirit of a classic David Letterman Top Ten, we’ve put together our own list, but with a twist at the end. KC visited The Street‡ and The Hays Advantage‡ on Bloomberg Radio to share his insights.
Listen…KC Mathews on the Hays Advantage‡
Below are the first two market and economic variables to watch in order to make sound decisions. In the next parts of this series, we’ll bring you more variables and three that perhaps, should be ignored. Let us worry about the rest of the noise.
10. Earnings Momentum
We are fundamental investors and believe that the primary driver of equity prices is earnings. Regardless of short-term noise that may move markets, sooner or later earnings and earnings momentum will determine market direction.
There is a 77 percent positive correlation between earnings‡ and equity‡ prices. Occasionally you will see equity prices deviate from earnings growth due to various reasons. Since 1955, however, earnings have grown 6.5 percent annually, and the S&P 500 has increased about the same, growing 7 percent on average. In 2014, earnings were up 5 percent and valuations‡ increased by 25 percent, resulting in the S&P 500 posting a 32 percent return.
We expect earnings growth to be in the 4 to 6 percent range this year and continue to expect positive returns in equities. We would not be surprised, though, if we experience a meaningful correction‡ to get earnings and market performance back in line.
9. High Yield Spreads
High yield spreads‡ will usually precede or confirm a material correction in the equity market. We define a material correction as a decrease of 10 percent or more and haven’t seen this type of a correction since June 2012. Market corrections are a normal and healthy part of a secular bull market. As the domestic equity markets continue to increase, the probability of a meaningful correction also increases. Historically, changes in high yield spreads have either signaled or confirmed a correction in the equity market. For example, in early 1998, high yield spreads widened 65 basis points‡ suggesting an oncoming correction. As expected, a 15 percent mid-year correction followed. Again, spreads widened by 90 basis points in the summer of 2007, right before the peak of the S&P 500.
In the past two years we have seen smaller corrections ranging from 4 to 7 percent with virtually no widening of high yield spreads. This tells us the meaningful correction has not yet occurred, nor is a correction on the near-term horizon.
Remember to check back for the rest of the variables to watch (and ignore) next month!
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K.C. Mathews joined UMB in 2002. As executive vice president and chief investment officer, Mr. Mathews is responsible for the development, execution and oversight of UMB’s investment strategy. He is chairman of the Trust Investment, Asset Allocation and Trust Policy Committees. Mr. Mathews has more than 20 years of diverse experience in the investment industry. Prior to joining UMB, he served as vice president and manager of the portfolio management group at Bank of Oklahoma for nine years. Mr. Mathews earned a bachelor’s degree from the University of Minnesota and a master’s degree in business administration from the University of Notre Dame. Mr. Mathews attended the ABA National Trust School at Northwestern University and is a Chartered Financial Analyst and member of the CFA Institute. He is past president of the Kansas City CFA Society and a past president of the Oklahoma Society of Financial Analysts.