Random Walk

THE stock market’s Thanksgiving-week turkey performance (the Dow Jones index dropped 107 points) provides yet another warning that the cyclical bull market that started in early 1991 may be coming to an end. So far this year, the average of four major market indices has declined by 3.5 per cent, compared to gains of 20 per cent or better in the prior three years. Small-cap indices such as Nasdaq and the Russell 2000 have posted an average 5.4 per cent decline, while the Dow and S&P 500 have averaged a 1.6 per cent drop. When the more volatile smaller caps underperform the larger ones, it often signals a growth slump or outright recession. This year’s relative performance is the opposite of what happened in 1991-93, when the smaller-cap indices outperformed the big guys, thus correctly signaling stronger future economic growth. So far this year, investing cash in three-month Treasury bills—with an average return of about 4 per cent— would have been the best bet.

Market historians note that an average bear market brings stocks down by roughly 20 per cent. So will stocks drop another 15 per cent or so? They could. One way to look at the issue is to compare the earnings yield of stocks (current company earnings divided by the current price) with the yield on gilt-edged Treasury bonds. Ten-year Treasury note yields over the past 12 months have jumped 50 per cent, from 5.2 per cent to 7.8 per cent. But the earnings yield for the S&P 500 has risen by just 36 per cent, from 4.4 per cent to 6 per cent. Unless Treasury yields fall significantly—an unlikely event if the Federal Reserve keeps raising interest rates—this implies a further stock-market correction of 14 per cent.

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THE stock market’s Thanksgiving-week turkey performance (the Dow Jones index dropped 107 points) provides yet another warning that the cyclical bull market that started in early 1991 may be coming to an end. So far this year, the average of four major market indices has declined by 3.5 per cent, compared to gains of 20 per cent or better in the prior three years. Small-cap indices such as Nasdaq and the Russell 2000 have posted an average 5.4 per cent decline, while the Dow and S&P 500 have averaged a 1.6 per cent drop. When the more volatile smaller caps underperform the larger ones, it often signals a growth slump or outright recession. This year’s relative performance is the opposite of what happened in 1991-93, when the smaller-cap indices outperformed the big guys, thus correctly signaling stronger future economic growth. So far this year, investing cash in three-month Treasury bills—with an average return of about 4 per cent— would have been the best bet.

Market historians note that an average bear market brings stocks down by roughly 20 per cent. So will stocks drop another 15 per cent or so? They could. One way to look at the issue is to compare the earnings yield of stocks (current company earnings divided by the current price) with the yield on gilt-edged Treasury bonds. Ten-year Treasury note yields over the past 12 months have jumped 50 per cent, from 5.2 per cent to 7.8 per cent. But the earnings yield for the S&P 500 has risen by just 36 per cent, from 4.4 per cent to 6 per cent. Unless Treasury yields fall significantly—an unlikely event if the Federal Reserve keeps raising interest rates—this implies a further stock-market correction of 14 per cent.