Global stock market valuation. When is the recession coming? Central banks are reducing the money supply.

Chart of the week

The chart shows the average volatility of the US stock market over the course of the year. The data series is calculated by the CBOE, one of the world's largest options exchanges in the USA. The black line shows the average over the last 30 years, and the red line shows the trend in 2023. The extraordinary peak in March, was the banking crisis.

Why it matters
Volatility is a measure of risk. From May to the end of July, the stock market often doesn't change much and risk is lower. From September to October, the risk is much higher.

Volatility is also important for investors who trade futures, that is, buy calls or puts to make money on the stock market with higher leverage. The higher the possible range of stock prices (volatility), the more expensive they are. Buyers of options should pay attention mainly from October to January. There it can be that the expectation of rising prices is correct, but because of the falling volatility the investment still makes a loss.

Global stock market valuation

The chart shows how much money flows into the stock market in the USA each week (light blue bars). The blue line shows the average of four weeks. For years, the majority of the blue line has been positive. This leads to a very high valuation of the shares in the USA.

The opposite can be seen in England. The chart shows the weekly money flows into stocks in England (light blue bar). The majority of the blue average line of 4 weeks is negative. Investors have been avoiding English equities since the BREXIT. These money flows lead to very different valuations.

The chart shows the price/earnings ratio of shares in various countries and regions in a 20-year historical comparison. In most cases, valuations are in the range of the blue bar, with the gray dot as the average. The valuation of stocks in the U.S. (orange dot) is well above the long-term average. The situation in England is quite different. Here the valuation is far below the long-term average.
Should one now sell shares in the USA and buy those in England? Not necessarily. There is a stock market saying: The trend is your friend. A trend usually lasts longer than you think and it takes an event to turn it around.

In the U.S., it could be disappointing quarterly numbers from one of the much-praised new companies working in artificial intelligence or new regulation. In the UK, it could be the announcement that the government is changing course and looking to get closer to Europe again.

The chart shows since 1971 in which phases the shares in Europe (purple) and when the shares in the USA (black) have a better return. In the past 50 years (calculated in USD), 38 years had a better return in the USA and only 12 years in Europe. The current out-performance of stocks in the US has been going on for almost 15 years.

When will the recession come?
Good economic numbers came out late last week. The U.S. inflation rate fell significantly in May. The central bank's favored price measure, the overall personal consumption expenditures (PCE) index, was 3.8 (previous month: 4.4) percent higher than a year ago. These figures were below expectations.

On the positive side, central banks are now unlikely to have to raise interest rates further after July, but the risk of a recession coming soon is rising. Investors are currently more short-term than long-term oriented.

In recent weeks, analysts' earnings expectations for companies' second-quarter results have been revised upward (blue line). However, earnings revisions usually have a high correlation with key leading economic indicators (black line). A similar discrepancy occurred in 2008 during the financial market crisis. Most investors expect a similar picture now. Since 1995, there has never been a case where the leading economic indicators were so negative and no recession came.

In overview, there is also a high correlation between the credit conditions for small firms (NFIB) and the unemployment rate. If small firms cannot invest, no new jobs are created. Since 1986, the discrepancy between the two comparative variables has never been so high. There are many indications here that the unemployment rate could soon rise sharply.

Central banks reduce the money supply
If the above signs were not already negative enough, central banks are currently reducing the money supply sharply.

The chart shows the performance of the S&P 500 Index compared to the liquidity provided by the Federal Reserve (red line). During the COVID period, it was evident that approx. 1/3 of the central banks' money did not flow into the economy, but into the stock market. A reduction in the money supply has always had a negative impact on the stock market. Currently, however, the stock market does not seem to care and continues to rise.

The chart shows the change in the U.S. federal funds rate M2. This is the first time in 90 years that it has been sharply reduced. The picture is the same in Europe.

The chart shows the change in the monetary base in Europe. For the first time since 1981, it has also declined sharply.

It is understandable that the central banks, having provided the economy with a large amount of money during the COVID crisis, are now taking countermeasures. However, there is a danger that the central banks are now giving too much counteraction and slowing down the economy too much.