Economic Indicators

Do stock prices confirm that firms with high market power maintain profitability during times of high inflation because they can raise prices, while those with low market power cannot? In their August 2023 paper entitled “Stagflationary Stock Returns and the Role of Market Power”, Benjamin Knox and Yannick Timmer study effects of inflation news on stocks of firms ranked by market power. They define:

• Inflation news as the difference between total consumer price index (CPI) releases and the median inflation forecast from Bloomberg back to 1997, and before that from Haver Analytics back to 1977.
• Market power as firm ability to set its price above marginal costs (markup), estimated as sales over cost of goods sold multiplied by the output elasticity of inputs (from a production function estimate).

They decompose stock returns into risk premium, risk-free rate and cash flow news components. They designate firms above the 75th (below the 25th) percentile of market power as high-market power (low-market power) firms to assess stock price responses to inflation news. Using total CPI releases, associated median inflation forecasts, accounting data for a broad sample of U.S. common stocks and daily returns for both individual stocks and the broad U.S. stock market during 1977 through 2022, they find that: Keep Reading

In response to “PPI and the Stock Market”, a subscriber hypothesized that increases and decreases in the ratio of the Consumer Price Index (CPI) to the Producer Price Index (PPI) are bullish and bearish for the stock market, respectively. The reasoning for the hypothesis is that CPI reflects aggregate corporate revenue, while PPI reflects aggregate costs. The ratio CPI/PPI therefore relates to aggregate profitability, which should translate to stock market level. To test this hypothesis, we construct U.S. CPI/PPI monthly from non-seasonally adjusted CPI and non-seasonally adjusted PPI. We then relate changes in this ratio to S&P 500 Index returns. Using CPI and PPI values and S&P 500 Index levels as available during December 1927 through July 2023, we find that: Keep Reading

Inflation at the producer level (per the Producer Price Index, PPI) is arguably an advance indicator for inflation downstream at the consumer level (per the Consumer Price Index, CPI). Do investors reliably react to changes in PPI as an indicator of the future wealth discount rate? In other words, is a high (low) producer-level inflation rate bad (good) for the stock market? Using monthly, non-seasonally adjusted PPI from the Bureau of Labor Statistics (BLS) and S&P 500 Index levels as available during December 1927 through July 2023, we find that: Keep Reading

During 1989 through 2019, the S&P 500 Index generated 5.5% real annual return, compared to just 2.5% annual real growth in U.S. gross domestic product (GDP). How can this disconnect happen? Can it continue? In the June 2023 version of his paper entitled “End of an Era: The Coming Long-Run Slowdown in Corporate Profit Growth and Stock Returns”, Michael Smolyansky examines interactions between U.S. stock market performance and declines in interest rates and corporate tax rates over the last three decades. He focuses on S&P 500 non-financial stocks adjusted for index additions/deletions and for changes in firm shares outstanding, allowing computation of per share metrics. He decomposes stock returns into: (1) change in price-earnings ratio (P/E);  (2) change in earnings before interest and taxes (EBIT); (3) change in interest expenses; and, (4) change in effective corporate tax rate. Using the specified annual data during 1962 through 2019, he finds that: Keep Reading

Does an expectation of an unusually large number of firm defaults in the coming year usefully predict stock and bond market returns? In their May 2023 paper entitled “Systematic Default and Return Predictability in the Stock and Bond Markets”, Jack Bao, Kewei Hou and Shaojun Zhang apply an iterative process to estimate the probability that non-financial, non-microcap firms will default during the next year due to exposures to common shocks. The main inputs for their estimate are: (1) firm-level balance sheets and past stock returns; and, as common shocks, (2) past stock market returns. They relate estimated next-year default rate probability, focusing on a threshold of 2% of firms, to future stock market and corporate bond market index returns at horizons from one month to five years. They conduct in-sample tests of the default rate probability-index return relationships based on all data. They conduct out-of-sample index return predictions based on inception-to-date data starting at the sample half-way point. For robustness, they consider default rate probability thresholds other than 2%. Using firm balance sheets/monthly stock returns, plus monthly value-weighted U.S. stock market index and Dow Jones Corporate Bond Return Index returns during March 1961 through December 2021, they find that: Keep Reading

The U.S. Bureau of Economic Analysis (BEA) each quarter estimates economic growth via changes in Gross Domestic Product (GDP) and its Personal Consumption Expenditures (PCE), Private Domestic Investment (PDI) and government spending components. BEA releases advance, preliminary and final data about one, two and three months after quarter ends, respectively. Do these estimates of economic growth usefully predict stock market returns? To investigate, we relate economic growth metrics to S&P 500 Index returns. Using quarterly and annual seasonally adjusted nominal final GDP data from BEA National Income and Product Accounts Table 1.1.5 as available during January 1929 through May 2023 and contemporaneous levels of the S&P 500 Index, we find that:

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How does the U.S. stock market typically react to U.S. debt ceiling discussions/actions? To investigate, we look at cumulative S&P 500 Index returns around actions to change the debt ceiling. Using daily S&P 500 Index returns and debt ceiling action dates during mid-June 1940 through May 2023 (90 quantitative actions), we find that: Keep Reading

Conventional wisdom holds that a steep yield curve (wide U.S. Treasuries term spread) is good for stocks, while a flat/inverted curve is bad. Is this wisdom correct and exploitable? To investigate, we consider in-sample tests of the relationships between several yield curve metrics and future U.S. stock market returns and two out-of-sample signal-based tests. Using average monthly yields for 3-month Treasuries (T-bill), 1-year Treasuries, 3-year Treasuries, 5-year Treasuries and 10-year Treasuries (T-note) as available since April 1953, monthly levels of the S&P 500 Index since April 1953 and monthly dividend-adjusted levels of SPDR S&P 500 (SPY) since January 1993, all through March 2023, we find that: Keep Reading

In his 2007 book The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing, expert Louis Navellier hypothesizes that growth (value) stocks tend to do relatively better when interest rates are rising (falling). Growth stocks benefit from the economic expansions associated with rising rates. Value stocks benefit from refinancing opportunities as interest rates fall. To test this hypothesis, we compare the performances of the following paired growth and value exchange-traded funds (ETF) and mutual funds as interest rates, proxied by the yield on the 10-year U.S. Treasury note (T-note), vary:

• iShares S&P 500 Growth ETF (IVW) and iShares S&P 500 Value ETF (IVE).
• Fidelity Growth Company (FDGRX) and Fidelity Value Fund (FDVLX).

We consider both abstract predictive power based on correlation of changes in T-note yield with future fund returns and explicit performance of a strategy that switches between value and growth according to changes in T-note yield. Using end-of-month dividend-adjusted prices for the selected funds and contemporaneous T-note yield starting January 1983 for the mutual funds (limited by FDGRX) and May 2000 for the ETFs, all through February 2023, we find that: Keep Reading

Do investors reliably react over short and intermediate terms to changes in the U.S. Consumer Price Index (CPI), a logical measure of the wealth discount rate? Using monthly total and core (excluding food and energy) CPI releases (for all items, not seasonally adjusted) from the Bureau of Labor Statistics (BLS) and contemporaneous S&P 500 Index opens and closes during mid-January 1994 (earliest available CPI release dates) through mid-March 2023 (351 releases), we find that: Keep Reading