At Woodhill we spend a lot of time studying economic and financial market history. We run a UK equities unit trust that hedges risk fully when we think the balance of risk and return is unfavourable.
For a long time, we have not considered the UK, or other major stock markets, to represent a sensible risk / reward profile. So, what do we need to see to allow us to get fully exposed to equities for the next major upturn?
- Normalised interest rates
- Longer term valuations that are at least constructive
- An upturn in lead indicators from a recessionary / cyclical low
If all three are in place, history suggests potentially years of positive above average returns lie ahead. Sometimes two out of three are enough.
1. Normalised interest rates
Out of the three key factors listed above interest rate normalization is the closest to have been achieved. After the interest rate increases, we have seen in the US and the UK we are now at levels that are somewhat normal. This is comforting for a few reasons. The first is that the exit from ultra-low interest rates was always going to be tricky. The most obvious recent manifestation of this has been the drama in the US banking system. There are probably some more issues to be resolved but we are at least well through the process of normalisation. The second reason why normalised interest rates are encouraging is that in the event of a recession or meaningful slowdown central banks now have the space to cut rates if necessary.
UK Short Term Interest Rates
The chart above shows both how extremely low UK interest rates got during Covid-19. For over hundreds of years, a ‘normal’ interest rate for the UK has been between around 2.5% and 5%. Currently base rates are at 4.25%. Could they go higher? Certainly, but we are now well into normal territory.
2. Valuation / stock market compared to GDP
A new and sustained bull market ideally starts when equities are cheap, or at least not expensive. The chart below shows the value of all equities in the US versus GDP. This indicator was made famous by Mr. Warren Buffet, who has described it as his favourite valuation tool. There is logic here as profits and equity values do themselves arise out of GDP, and cannot, for the long term, be entirely separate from each other. In an ideal world it would be nice to see this ratio at 100% or less. The whole of the 1980s and 1990s bull market took place as this ratio slowly crept up to 100% and then ultimately entered bubble levels in 2000. As this millennial bubble deflated it became much safer to buy once the indicator fell to below 100%. The same thing occurred following the financial crisis of 2007/8. Now we are still some distance away from this ‘good value’ level.
Total value of all US publicly traded stocks / GDP ratio
3. A turn in economic lead indicators from a ‘low’ level
The chart below shows an indicator called the US composite lead indicator. This is a fast-moving measure of economic momentum in the US. If interest rates are normalised and if equities are not overvalued this indicator is, then, an excellent utility for knowing when it is safe to get back in the water. In essence if this indicator falls to 97 or below and then turns up this is a strong signal for those who are waiting to buy. A turn upwards from such a relatively low level is needed as it makes it clear to investors that the worst is probably over. As can be seen in the chart this index can fall well below 97 and waiting for the upwards turn is important. Otherwise, even if equities are somewhat cheap an investor can end up buying a little too early.
US Composite Lead Indicator
Interestingly the lower the downward move is before it turns up the better the resulting bull market becomes. This is even more so if equities are ‘good value’ and if interest rates are somewhat normal. At the moment this indicator is at 98.5. This suggests that further economic weakness would be necessary before a successful upturn can be counted as having happened.
So where are we overall and what do we need to see?
In short, we are getting there. Interest rates are back to levels that can be recognised as being normal. However, for a sustained and powerful bull market we want to see equities become cheaper than they are now. Ideally the “Buffet indicator” would be at 100% or below. Finally, we would need to see a little more economic weakness and ultimately an upwards turn from US Composite Indicator of 97 or below. Interestingly if a genuine patch of economic weakness takes place from here (we believe this to be likely) then the Buffet indicator is also likely to come down. This would be the ideal situation.
Paul Wood CIO
Woodhill Asset Management