Macroeconomic variables -- Weak signals of market moves

A. Srikanth

ANALYSTS tracking investment trends, or equity style-timers, as they are called, contend that the outperformance of either value or growth stocks can be traced to certain economic fundamentals, business cycles or corporate earnings.

Equity style practitioners have traditionally used economic factors such as yield curves, GDP growth, earnings-yield gap and inflation. Analysis shows that macroeconomic indicators have not been of much help in tracking the performance of the stock market over the last two years. They have, at best, served as weak signals of a shift in trends.

Empirical research has shown that growth stocks, whose valuations typically rely on expected earnings growth farther into the future than value-stock valuations, may be said to have a longer duration than value stocks. Consequently, rising interest rates would disproportionately hurt the discounted value of a growth company's earnings stream. Thus, growth stocks tend to underperform in a steep yield curve, which implies rising interest rates in the future.

A look at the government and corporate bond yields over the last two years indicates the subsequent trends. The yields of government securities and corporate bonds were on the uptrend from April 1998 till the end of the year. But they declined from early 1999. This should, logically, have augured well for the growth stocks, but they underperformed the value stocks between April and October 1998. However, as the yields declined steeply, from September-October 1998 to May 2000, the growth stocks outperformed the value stocks.

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GDP growth rates reflect corporate profit cycles. During expansionary periods, when corporate earnings are expected to be high, operating leverage contributes disproportionately to the profitability of value stocks. Hence, they are expected to outperform the growth stocks in these periods. The sharp uptrend in GDP growth rates in the first half of 1999-2000 resulted in value stocks outperforming the former. However, as fears of a slowdown gripped the market, the investment style appears to have switched back to growth stocks again.

Empirical research has shown that the earnings-yield gap has traditionally exhibited the highest correlation with style spreads. When corporate bond yields are subtracted from the earnings yield (E/P ratio, which is the inverse of the P/E ratio) we get the earnings-yield gap. A low E/P ratio with high interest rates would mean a low earnings-yield gap, which would be favourable for value stocks. On the other hand, a high E/P ratio and low interest rates means growth stocks outperform value stocks.

The E/P ratio and the corporate/government bond yields have been on the downtrend since the beginning of 1999. This signifies a low earnings-yield gap and, consequently, should not favour growth stocks. On the contrary, except for a brief period between April to October 1999, growth outperformed value. Macroeconomic indicators have, thus, served as weak signals of stock market activity.