How to Forecast the Stock Market from a Macro Perspective

PE Ratio

My letter to the Financial Times regarding the recent article discussing stock market fragility and the debate over the interpretation of data between Robert Shiller and Jeremy Siegel has been published. In the letter I try to draw attention to an article I wrote for the FT Alphaville blog back in July showing how we could combine the Levy-Kalecki Profit Equation with Shiller’s index to make medium-term projections about the trajectory of the stock market.

While the FT Alphaville blog lays out my argument in more detail this is basically the crux of it:

The robustness of the stock market is generally gauged by looking at the price-earnings ratio (P/E Ratio). While this is by no means a perfect measure, it gives us a good idea of how solid stock market rallies might be. Now, the P/E Ratio has two components: prices, which are dictated by the buying mood of the markets, and earnings, which are largely driven by macroeconomic profits.

In the piece I point out that the best measure of the drivers of macroeconomic profits is the Levy-Kalecki equation. Thus by studying the evolution of macroeconomic profits in the economy we can then make projections about future corporate earnings. This, in turn, allows us to guess in what direction the P/E Ratio is heading; a fall in macro profits will cause it rise, while a rise in macro profits will cause it to fall.

Personally, I think that this is the best way to make medium-term macroeconomic projections about the stock market. It does not provide us with a ready-made answer — indeed, one would be hard to find the level that the P/E Ratio must reach before a crash definitely happens — but it does allow us to keep at the back of our minds the likely evolution given the macroeconomic fundamentals.

At the time of writing I took note that macroeconomic profits were likely on a downward course due to the sequestration at the beginning of the year and the subsequent fall in government deficits (the key driver of macro profits after the 2008 crisis). The figures for the P/E Ratio as they stood then were as follows:

January 2013: 21.90

July 2013: 23.49

And today they are as follows:

September 2013: 23.67

That’s a pretty slow crawl, of course, but the ratio certainly hasn’t fallen since I wrote that piece. Let’s have a look at where it is this coming January.

For now, as I pointed out in my letter, one really needs to keep an eye on the government deficit in the US as this is the main driver of macro profits. This is simplified advice for working investors, but one would do much better with proper data on all drivers of macro profits.

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About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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