Expect More Headwinds For The Us Stock Market

2018 hasn’t been a good year for the US stock market and we expect more volatility going forward. We might very well see new lows in the coming months.

Judging from the general media coverage the reason for stock market volatility primarily has to be found on Pennsylvania Avenue 1600 – i.e. in the White House – and there certainly is no doubt that President Trump’s mostly ill-advised tweets scare investors. However, it is also worth noting that investors ignored Trump for a very long time.

If we are to analyze developments in the stock market, then it might be more reasonable to focus on factors that normally drive the stock market instead of focusing on the daily blunt attacks from the US president.

Basically, there are three factors that drive the stock market over the longer term. First, earnings development and expectations for future earnings (positively). Second, the development of interest rates (negatively) and, thirdly, what we call the risk premium (negatively).

We have used these three factors to estimate a simple model for S&P 500. In the model, we use potential nominal GDP as a proxy for long-term earnings growth. We use corporate bond yields as our measure of interest rates and we estimate the risk premium by looking at macroeconomic (in)stability measured as the volatility in quarterly growth of nominal GDP.

As the graph below shows the model does a good job explaining the overall trends in S&P 500 since 1970 and we see that through most of this period the actual level of S&P500 is within one standard deviation of the model ‘prediction’.

All three factors have supported the US stock market performance since 2009-10, but in recent months development has begun to reverse.

Firstly, the US Federal Reserve has begun to signal a more aggressive tightening of monetary policy in the forefront of inflationary pressures. It reduces expectations of US growth and thus also earnings development in US companies. At the same time, US long-term interest rates have already risen somewhat since autumn – mainly due to a significant easing of US fiscal policy. Upon of that, it is also clear that the noise from the White House naturally contributes to increasing the risk premium on American stocks.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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