Are the Good Times Over?
|Date:||31 January 2019|
|Author:||dr. Lammertjan Dam|
Last December, Dutch stock prices dropped dramatically. Are these the first signs of the next recession? Inspired by two blogs by John Cochrane, I decided to have a look myself at the underlying indicators. (Prof. Cochrane was kind enough to e-mail me his code to produce the figures, so I could redo the analysis with Dutch data.)
In sum, I don’t think we should panic. The Dutch stock market seems to be in a similar shape compared to the U.S. – perhaps even better.
Stock Returns and Volatility
Sure, in 2018 Dutch Investors ended up with losses. But as the upper-left panel of figure 1 shows, this yearly loss is fairly mild compared to most of the years with a loss of the last 36 years. Taking into account that before 2018 we had six consecutive good years, long-term investors have nothing to complain, really. With a volatility of around 25% annually (upper-right panel in figure 1), every once in a while we can expect a bad year. But because markets are unpredictable, a bad year certainly does not mean that we face a recession. We have had quite low volatility in recent years, and now it has gone up somewhat again. Of course, if the market becomes more risky, investors require a higher return. Given the promised dividends, they can get a higher return if current prices drop temporarily.
“But if we had a boom period of six years, surely the market is overpriced, right? The “bubble” should burst at some point, is it not?” Well, price levels alone do not tell us that much. If the growth of profits has been even larger, the market could actually be “underpriced”. The lower-left panel of figure 1 shows the AEX index price level scaled by aggregate dividends. The current Price-Dividend ratio is around 30, which is historically not abnormal – certainly not compared to Price-Dividend ratios of almost 60, as we had in the 90s. For a long term investor, a dividend yield of 3.3% (1/30) is great compared to the current interest rates. So, linking prices to fundamentals does not hint at an overpriced market.
It is a good idea though, to keep an eye on the term structure of interest rates. With the limited time series for the Dutch AEX index this is not so clear, but for U.S. data it is well established that a good predictor for a stock market crash is when short term interest rates are higher than long term interest rates. The lower-right panel plots both the 2-year Dutch government bond yields and the 10-year Dutch government bond yields. We see that just before the crisis in 2008, the 2-year yield line crossed the 10-year yield line. Currently, however, short term yields are very low – negative even – and so there is still a spread of about 1% with the 10-year yields. (But is the gap between the two lines perhaps closing?)
As goes January, so goes the year?
So the situation is very similar to the U.S. and with a larger gap in interest rates perhaps even better. It seems that the sudden drop in December was a “correction”, volatility has increased somewhat and investors require a higher return. To establish this, price levels need to be temporarily lower. But the signs indicate that the market will probably bounce back up, as it already did for a large part in January. Sure, economic growth is cooling down, but the current state of the market is not as bad as some media coverage suggests.