The recent US – China trade wars has sparked another round of stock market volatility in the past couple of weeks. But despite the headline risks, the underlying macro-economic picture in Australia and the United States continues to look strong.
Our research suggests that stock market cycles don’t tend to peak and enter a bear market phase until you begin to see signs of deceleration in economic growth. At UGC we look at 5 key macro-economic factors to determine if the broader investment environment is displaying above average levels of risk.
Specifically, big bear markets don’t tend to start until you see the following five factors flash red all at the same time.
- Economic Growth – economic growth both locally and globally begins to decelerate
- Interest Rates – interest rates at the short end of the yield curve are higher than the long end (yield curve inversion)
- Asset Valuations – asset prices are inflated and well above historical averages
- Investor sentiment – investors are wildly bullish on the outlook for stocks and the economy, and
- Financial Stress – credit spreads between high grade corporate debt and low grade corporate debt widen
For us to become seriously concerned about the beginning of a major bear market, we would typically want all 5 of these conditions flashing red or at least 4 flashing red and 1 flashing amber.
This week we’ll look at Australian and US economic conditions.
In May we saw the Australian unemployment rate decline from 5.6% to 5.4% after hovering around 5.5% for the 4 months of December, January, February and March. A declining unemployment rate is not consistent with a macro-economic environment which is conducive for a stock market peak and a large crash getting underway.
This decline in unemployment also comes on the back of a very healthy trend in Australian GDP growth. Over the past 5 quarters we have seen a general strengthening in Australian economic growth, with GDP rising on an annual basis from 1.8% to 3.1%. Big bear markets don’t generally get started when economic conditions are improving. The peak in stocks usually happens after some evidence of deceleration in economic growth, which is certainly not evident yet.
The story is the same when looking at the world’s most important economy, the United States. Unemployment in the US has continued to trend lower as the chart below shows. There is no sign of weakness yet.
Furthermore, US GDP growth continues to strengthen and trend higher. No sign of weakness yet either.
While this current equity market cycle is no doubt very mature in terms of its longevity, the economic conditions we are seeing today suggest that the long term macro-economic conditions are still conducive for further stock market gains in the immediate future.