September 4, 2023
While economists, business leaders and analysts are concerned...
... investor confidence has pushed stock market indices to all-time highs
Are markets highly predictive or, on the contrary, abnormally inefficient?
In any case, the opportunities are rare

CHARTS OF THE WEEK: "How to close such gaps?"

How to close such gaps?


The concept of market efficiency is essential in finance. It suggests that asset prices reflect all available information at all times. Efficiency derives not only from the accessibility of this information, but also from the cognitive capacity of investors and their behaviour. If investors are well-informed, competent, rational, and able to act quickly, then they contribute to the creation of a market that accurately and instantaneously reflects the fair value of assets. This makes it impossible for an investor to achieve a higher return without taking on additional risk. We recently analysed the fact that this is not currently the case, and that a trade-off could be made between equities and bonds, in favour of the latter whose expected returns are similar for less risk (see WIF 14 August).

This new analysis, linked to the economic cycle and corporate profitability, highlights other forms of equity market inefficiency. Logic would dictate that equity indices should accurately anticipate macro and micro-economic trends. However, since the end of 2022, the rise in stock market indices has contrasted with trends in several fundamental variables :

1. Sluggish activity indicators (see Fig. 2)

Investors rightly believe that listed equities grow in line without put growth. While this relationship is not guaranteed over short periods, such as 2021, it is one of the strongest over the long term. In 2023, given the economic fundamentals, the surge in equity indices appears to have been disproportionate once again. To close the gap between the economic situation and stock market performance, we would need either GDP growth of +4%, a stock market correction of -12%, or a combination of the two.

Fig. 2 - Equities vs economic activity - Fig. 3 - Equities vs margin debt
Fig. 2 - Equities vs economic activity - Fig. 3 - Equities vs margin debt

2. The earnings squeeze on listed companies (see Charts of The Week)

All other things being equal, the more profits companies generate, the more their share prices appreciate. Conversely, when profits shrink, a stock market correction occurs. To justify an S&P 500 index at USD 4,500, earnings would have to rise by +14% from their current level, a far cry from historical norms during a recession (-12%to -44%).

3. Declining global liquidity (see Charts of the Week)

Since the Great Financial Crisis (GFC) in 2008-2009, central banks have adopted new monetary policy tools. One of these is to inject excess liquidity into the economy (quantitative easing) in order to stimulate growth and inflation. To do this, central banks buy up large volumes of financial assets, which automatically boosts stock prices. For the past 18months, central banks have been seeking to reverse this policy (Quantitative Tightening). This reduction in balance sheets naturally contributed to the stock market correction of 2022. However, since April 2023, the relationship seems to have been broken, otherwise stock market indices would be -20% to -25% below their current level.

4. Low margin debt (see Fig. 3)

When buying shares, investors have the option of financing the entire purchase themselves (using their own resources, also known as 'margin') or borrowing part of the capital required from a broker (using 'margin debt'). Volumes of margin debt tend to increase as stock market indices rise. Today, these volumes are abnormally low, indicating that investors are making little use of leverage. The first explanation is the high level of interest rates, which increases the cost of borrowing on margin accounts and mechanically slows down investor leverage. The second explanation is linked to the level of unease felt by professional investors. Even if stock markets are performing, if they believe they are overvalued and need a correction, they will be reluctant to borrow and expose their portfolios to more risk. To offset the gap between the level of equity indices and the volume of margin debt, the former would have to contract by -20%, while the latter would have to rise by +20%.

Fig. 4 - Equities vs. the consumer cycle - Fig. 5 – Equity valuation & investor optimism

5. The underperformance of consumer cyclicals (see Fig. 4)

When the economy is booming, cyclical consumer goods companies, such as automobiles, tourism, or capital goods, tend to see their revenues rise more sharply. On the other hand, consumer staples such as food, personal care products, medicine sand utilities enjoy more stable demand and more regular revenues, even in times of crisis. In addition, consumer discretionary companies often have greater operating leverage than consumer staples companies. As a result, a small increase in sales enables them to generate proportionately greater growth in profits. Over the past two years, investors have struggled to maintain the historical relationship between rising stock markets and the outperformance of consumer cyclicals. Despite the catch-up in 2023, there is still a significant gap of +/- 20% between them.

Conclusion :

Based on these examples, the bull market is not driven by fundamental factors. Only individual investor's optimism and valuations have risen (see Fig. 5). The gaps to be filled are large. Either the economic cycle and corporate earnings improve rapidly, or the next stock market correction will be sharp.

Financial Research