Academic research finds a recurring pattern in financial crises. Investors and borrowers tend to extrapolate, expecting the conditions of the recent past to continue. These dynamics lead to self-reinforcing uptrends in credit, investment markets, and the economy, causing the Value (likely return relative to risk) of investment assets to deteriorate.
Market busts and financial crises arise when optimistic beliefs are disappointed. The usual source of disappointment is a downturn in economic growth. The headline description for most of the equity bear markets in US history is: “Stocks were expensive, and then there was a recession.”
Economic growth drives earnings growth, and earnings growth drives stock prices. As a consequence, changes in the economy and in stock prices are closely aligned. To track changes in the global economy, Atlas tracks the most important economic data from the fourteen countries with the largest GDP. We use the data to create a big-picture view of economic changes. The two lines on the chart below are the one-year change in global stock prices (in green) and the percentage of the economic data which improved in the prior year. It’s quite evident from the chart that equity price changes are tightly interlinked with economic changes.