Market efficiency warrants caution in stock market optimism
After the stock market correction in March 2020, stock markets have been anticipating a strong post-corona economic recovery in recent months. This raises questions about the correct valuation of share prices. From an economic perspective, the current stock market rally is too strong. We can substantiate this view by looking at an index that measures market efficiency. At the same time, we have to recognise that exceptional factors, such as extremely accommodative monetary policy and strong fiscal stimulus, as well as the accelerated introduction of technology, continue to create a favourable environment for equity markets. Nevertheless, our analysis of market efficiency calls for caution in response to the current stock market optimism.
Trades versus economics
While the economic recovery after the corona crisis has been relatively difficult to get off the ground, stock markets around the world are in good shape. Many investors saw the massive stock market downturn in March following the global coronavirus outbreak as an ideal entry point. The strong stock market rally that followed convinced more and more people. Many young people continue to find their way to the stock exchange, partly thanks to the technological possibilities that facilitate this. The crucial question is whether the recent rally in stock prices is fundamental and lasting.
The IMF warned last month in its "Global Financial Stability Update" of a discrepancy between the recovery in the financial markets and that of the real economy. In its valuation models of the European and US equity and bond markets, the IMF categorises the current overvaluation as the highest in the last thirty years. A correction of this overvaluation may not only lead to increased stress in the financial markets but may also have consequences for the real economy. A stock market correction typically leads to a drop in confidence and a further postponement of investments in uncertain times. It is typical that many governments and central banks welcome and even support the current stock market optimism, as recently revealed by statements by the Chinese government.
Nevertheless, it is important to keep an eye on the economic fundamentals. They are, certainly in the longer term, decisive for stock market developments. A popular angle here is the principle of market efficiency. If markets work efficiently, then all publicly available information is included in prices. In other words, yesterday's prices have no influence on today's price changes. Consequently, prices move arbitrarily. Observing the stock markets, this does not always seem a realistic assumption. Indeed, with full market efficiency, bubbles could not occur.
To visualize market efficiency, we use simple methods from information theory, which try to describe how randomly a time series moves, or how much information yesterday's prices give about today's prices. We apply the method to the NASDAQ-100 and the S&P500. When the randomness is maximum, the indices from Figure 1 reach their maximum. When an index falls, the randomness decreases and thus also the market efficiency. In theory, a drop in randomness of a stock index could be related to an undervaluation of this index, where a correction could lead to an increase in stock prices. However, we only observe this to a limited extent in the aftermath of the Internet bubble.
If we look at the evolution over time, we can derive a number of points. A first striking observation is the strongest decline in market efficiency in the period prior to the bursting of the Internet bubble in March 2000. In itself, a lack of randomness does not necessarily equate to a strong under or overvaluation of the markets, just as strong stock market fluctuations are theoretically perfectly possible in an efficiently functioning market. Nevertheless, we note that the most important events in US stock markets over the past 20 years, with the exception of exogenous shocks such as the outbreak of the coronavirus, have always been preceded by a lack of market efficiency, the latest being the (limited) stock market correction in autumn 2018. One could describe such announcements as herd behaviour as we observe in the formation of a bubble or as a reluctance to translate the seriousness of a situation immediately into share prices. After all, both mean a drop in market efficiency.
As a result of the corona crisis, stock markets around the world corrected rapidly in March of this year. Since the start of the stock rally at the end of March 2020, the indices in Figure 1 have been falling again. From a historical market efficiency perspective, the current levels again seem worrying.
Such a graph can also be drawn up for the S&P 500. The trajectory of the S&P500 market efficiency index is similar to that of the NASDAQ, with the exception of the dot-com bubble. Also with the S&P500, the herd behaviour of the past months is noticeable. Sometimes it is interesting to analyse sector by sector, for example there was a clear decline in the market efficiency of real estate shares from 2003 to 2007. When we zoom in on the different sectors, we notice that today the exaggerated optimism is mainly present in information technology and communication services. However, it is not impossible that this optimism will spread to other sectors or that any value adjustment will also have consequences outside the technology sector.
From the point of view of market efficiency, which has been a successful indicator of stock market corrections in the past, we can therefore endorse the idea of overvaluation in certain equity markets. However, it would be unwise to approach the strong stock market rally from only this side. After all, the corona crisis also has a number of structural consequences for our way of living and working. Information technology and communication applications will probably be used more intensively in the future and be implemented more quickly in production processes and in our daily lives. The recent boost in such shares can therefore be justified, provided that the current trend is sustained and that the high expectations are met.
More generally, massive monetary and fiscal stimulus is supporting the economic recovery. Low interest rates, in particular, make equity investments especially attractive. Nevertheless, it would be wrong to ignore the signals from an analysis of market efficiency. After all, they have proven their worth historically. That is why we continue to be cautious in our investment strategy, despite the relatively favourable economic outlook and strong policy incentives.