Several financial analysts and statisticians have uncovered an interesting, albeit disturbing, correlation that shows an inverse relationship between the number of daily tweets by President Donald Trump and stock market performance.
Analysts at Bank of America Merrill Lynch, for example, found that when Trump sends out more than 35 tweets per day (90th percentile), the S&P 500 drops an average of nine basis points. But when he’s relatively silent, sending out 10 or less tweets per day (10th percentile), the market increases about five basis points.
Although this correlation has been found to be statistically significant, we don’t see how it can be used as a predictive tool. By the time anyone counts Trump’s tweets, it’s probably too late to do anything about it. As for trying to forecast Trump’s tweeting capacity on a single day, that’s beyond our pay scale.
While many don’t like Trump’s use of Twitter, this type of communication is here to stay among politicians who want to get their messages out to the public without the media deciding what is important. For example, students tell us they read many more Trump’s tweets than articles about him in the Los Angeles Times or the Orange County Register.
When it comes to trying to forecast the stock market, we’re old school. Basically, we feel analyzing stock market fundamentals will give useful guidance regarding broad market trends.
Since those long-term trends are determined principally by corporate earnings, we like to focus on the inverse of the price-earnings (P/E) ratio, namely the earnings price (E/P) ratio. In a nutshell, the E/P ratio is the average rate of return when investing in the market. The earnings number is based on the most recent trailing 12 months while the price is based on the most recent stock price at the time.
Chart 1 shows a comparison of those returns from investing in the stock market (E/P ratio) versus bonds (10-year T-Bond rate). As shown in that chart, the current estimated E/P ratio of 4.4% is 250 basis points higher than a 10-year T-Bond offering 1.9%. That 2.5% average premium for investing in stocks versus bonds is a strong incentive for investors to keep their money in the market or even add to it.
What might happen to the stock market if a recession occurs? Trends in several economic variables, including recent articles in this column, point to a slowing economy and even the possibility of a recession next year. If such a recession occurs, will accompanying declines in the market lead to sharp financial losses—losses that will wipe out the gains from the current 2.5% return premium?
A review of every recession in the U.S. since 1965 points to the distinct possibility of large potential market losses. As shown in Chart 2, declines in the S&P 500 index from the market peak to trough during recessions ranged from -9% in the 1990-91 recession to a negative 48% during the recent Great Recession 2007-09.
It is interesting to note that the stock market continued climbing during the 1980 recession. That accounts for the “not applicable (N/A)” in Chart 2 for that recession. Also, note that the difference between the E/P ratio and the 10-year T-Bond was 3.3% at the start of that recession—not far from today’s 2.5% difference shown in Chart 1. In all other recessions, the stock market peaked when T-Bonds paid a higher return than the stock market. In the 2007-09 recession, the difference was positive, but only barely at 1%.
There are several recommended investment strategies implied by the above findings. For example, if one doesn’t believe a recession is imminent, despite whatever evidence there is to the contrary, that person should stay in the market. That 2.5% premium is just too good to pass up.
On the other hand, if one is risk-averse and frets about the looming possibility of a recession, it’s probably best for that person to reduce the proportion of equities in an investment portfolio. If one is obsessively risk-averse, one may want to sell off all equities and get out of the market completely.
As for us, we’re more tolerant of risk (call us “betting men”). We think the laws of probability favor staying in the market or until the 2.5% premium shrinks to 1% or lower.
That’s why we’ll be carefully watching that all-important E/P ratio and seeing how it compares to the latest 10-year T-Bond rate.
Who knows? If the premium remains at 2.5% or higher, especially if long rates trend towards negative, the market may continue strong even in the face of a recession … kind of like that N/A in the 1980 recession.
James Doti is president emeritus of Chapman University. Fadel Lawandy is director of the university’s Hoag Center for Real Estate and Finance.
