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The stock market is a leading indicator of business activity. It usually peaks before recessions begin and starts to increase before recessions end. In the postwar era, the S&P 500, adjusted for price inflation, has been remarkably consistent: In seven of ten recessions, it hit bottom four or five months before the recession ended. Thus, the increase since early March in the S&P 500 and major stock indexes is an encouraging sign.
However, most of AIER’s other leading indicators are still signaling recession. Until more of them start expanding, it would be premature to forecast a business recovery. Also, there is one glaring exception to the stock market’s postwar record as a reliable leading indicator. The stock market plummeted before, during, and after the 2001 recession, and the constant-dollar S&P 500 index kept falling for another 15 months after the recession ended. Stock prices fluctuate not only in relation to the business cycle but relative to the intrinsic value of corporate businesses. Key measures of this relationship provide a gauge of investor sentiment. They are not useful as a guide for timing turning points in the stock market, but they are helpful for determining whether stocks are trading at a premium or discount relative to net worth, earnings, and such. The chart below shows how the market value of stocks has fluctuated relative to corporate net worth since 1952. Two measures of net worth (total assets minus total liabilities) are used. In the top line, the net worth portion of the ratio is calculated using the historical cost of corporate assets. In the bottom line, the market value or replacement cost of tangible assets are used to calculate net worth. 
As can be seen, the market value of stocks has fluctuated widely as a percentage of both measures of net worth. By the end of 2008, both percentages had fallen sharply and reached their lowest level since the mid-1980s. At the current level, the value of stocks, as a percentage of net worth, is near the low end of its historical range. It is well below the peaks of the 1960s and the late 1990s, but higher than it was during the long bear market of the 1970s, when stocks were relatively cheap. At bottom, these and other financial ratios measure investors’ enthusiasm for stocks. There is no right level. The ratios have varied greatly, and a low ratio is not necessarily a buying opportunity. Investors who bought stocks in 1975, when stocks were cheap according to these ratios, saw the S&P 500 continue to decline, in real terms, until 1982. On the other hand, investors who bought stocks in 1982, when the ratios were still low, subsequently enjoyed the greatest bull market in U.S. history. The dilemma now for investors is wondering whether investor enthusiasm down the road will more closely resemble the experience of the 1970s or the 1980s. This commentary is based on a longer discussion of key measures of the relative valuation of stocks in the April 20, 2009, issue of Research Reports, available only to subscribers. To subscribe to AIER Research Reports, please become a Sustaining Member of AIER. Membership starts at just $39 per year.
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