What indicators predict stock market performance?

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If you follow the markets, you’re inundated with data. The usual implication is that this data is actually meaningful, or more precisely, predictive of stock market returns. Intuitive arguments can be made for many economic indicators including interest rates, unemployment, inflation, and various measures of stock market value. But which of these are just noise and which are truly predictive? We analyzed several commonly reported indicators to see which correlate with subsequent returns of the S&P 500.

Correlation Coefficients

This table tells us how these various indicators correlate to each other and to stock market returns. We see that these indicators offer little towards predicting next year returns but they all correlate significantly with 5-year returns. What about direction? Is a high or low value good for stocks?

Beta

This table of Beta values indicates the directional relationship between each indicator and the market.

Intrinsic Value

There are a couple metrics here, including PE Ratio and Price-to-Book Ratio, that essentially give an estimate for the intrinsic value of the stock market. When these are low, stock are cheap. Intuitively it follows that if you invest in an asset when it’s cheap, you can expect higher returns. That’s just what the negative beta values tell us.

Yield Spreads

There are two yield spreads that correlate well to stock market returns. The first is the Treasury Spread, which is the difference between interest rates on a 10-Year Treasury bill and a 3-Month note. This spread is a measure of how much investors expect interest rates to rise. A higher value indicates that investors expect improving market conditions, and predicts higher subsequent stock market returns.

The Stock-Bond Spread is the difference in the effective yields between stocks and bonds. Stock yields are calculated as the earnings yield (1/PE Ratio) plus the dividend yield. The higher this spread, the better an investment stocks are relative to bonds, and that’s what the data shows. A higher Stock-Bond Spread indicates favorable conditions for stocks.

Unemployment

An interesting result is that the Unemployment Rate shows a high correlation with stock market returns, but not in the direction we’d expect. The beta value is positive, meaning a higher level of unemployment correlates to higher stock market returns in subsequent years. Typically we consider low unemployment to be indicative of positive economic conditions, and it would follow that stocks can be expected to perform well. However, after some consideration of the data we conclude that the Unemployment Rate is either a coincident or lagging economic indicator. Positive economic conditions reduce unemployment, not the other way around. Since the stock market often leads the economy, a high level of unemployment is more likely to mean that stocks have recently plummeted, meaning they’re cheap. So counterintuitively, a high level of unemployment usually corresponds with cheap stocks and subsequent appreciation in stock value.