How to spot market tops: Macroeconomic Indicators

In a previous article, we outlined 5 ways to spot market tops. In this article, we look at how macroeconomic indicators such as GDP growth, unemployment rate and consumer confidence, together, can be a useful guide to identifying dangerous economics conditions for a potential market top.

1. GDP growth

Quite often, stock market tops coincide with periods of high reported annual GDP growth. That is, you have to have the boom before you have the bust.

The following chart shows how the S&P 500 often peaks at, or just after, the strongest readings for annual US GDP for the preceding period.

Source: Federal Reserve Bank of St. Louis

Furthermore, markets also tend to top well-before a recession takes place, as the chart below shows.

S&P 500 Historical Data

Data is inflation-adjusted and uses a log scale. Shaded areas indicate recessions.
Source: macrotrends.net

Where are we today? Well as we can see from the RBA’s data below, world GDP growth does not appear to be peaking. Rather it appears to be strengthening, and at the very least, bottoming.

Source: RBA

So, importantly, we are not saying that strong equity market performance is in fact correlated with strong GDP growth, but rather that strong GDP growth is often a precursor to poor market performance.

But what about if we combine this with other macroeconomic indicators? Can we garner even more confidence in our outlook for stock returns and a potential elevation in risk?

2. Unemployment rate

The unemployment rate is another important indicator of economic activity. It correlates negatively with stock market returns, especially since the 1990’s, and can sometimes start rising before the stock market starts falling.

S&P 500 vs Unemployment Rate
Source: GailFosler Group

Since the 1990’s

Source: GailFosler Group

For example, we can see how unemployment bottomed just before the 2007 stock market peak.

Currently, the unemployment rate in the US is close to historical lows, but so far shows no signs of bottoming.

Source: Federal Reserve Bank of St. Louis

3. Consumer confidence

Consumer confidence, which measures consumers’ optimism about their financial situation, is an important “soft” economic indicator that can also be useful for predicting market tops. The following chart shows the S&P 500 and consumer confidence, both relative to their respective trend lines.

Source: DSHORT

The correlation was particularly relevant before the last two market crashes (2000 and 2007). More recently, the relationship has also been significant.

Source: BlackRock/Business Insider 

At the moment, the Michigan Consumer Sentiment index is close to the levels of the late 1980s and mid 1990s, when equity markets tended to perform quite well for the year or two ahead.

Source: Federal Reserve Bank of St. Louis

So overall, these indicators, used in combination, can be a useful guide to predicting market tops, and the current market does not appear to be about to peak.

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