A few words have become immensely popular in the past few weeks, namely the oft-sighted 'green shoots' of recovery and the more recent 'start of a new bull market' If we're to believe some of the market's leading strategists, the rate of decline in GDP growth is slowing in the global economy – hence those green shoots – and global stock markets are as usual ahead of the curve, and surving ahead.
So how do we know if the market is really recovering? Some use 'gut instinct'. But many analysts choose to adopt a more rigorous approach to judging whether markets are worth buying or not.
In essence, this approach asks investors to look on the stock market as a whole, in aggregate terms, and then ask whether the market is cheap or not. What constitutes 'cheap' is, as you would expect, subject of much debate – but a small number of key measures or metrics tend to crop up frequently. Most of these measures – the Q Ratio, CAPE, volatility – suggest that the market is fair value at worst and cheap at best.
But many of these measures are simple snapshot tools. Valuation-based approaches offer a potentially stronger indication of future returns. Analysis by economist Andrew Smithers, of research firm Smithers and Co, suggests that those periods displaying the biggest underpricing – relative cheapness – produced the highest long-term returns. Other studies have produced similar conclusions.
But there's one crucial caveat to this approach: 'value' is a fairly poor short-term indicator but an excellent long-term one. If you're looking for short-term indicators, many economists concede that technical analysis is better suited, with most suggesting that short-term price momentum is the best indicator.
Whether we like it or not, the best market for judging the relative value of global stock markets is the US. Only with indices such as the S&P 500 and Dow Jones Industrial Average do we have long enough statistical series to make any meaningful analysis. This focus on the US markets shouldn't trouble British investors greatly as the statistical correlation between the US and UK markets is fairly high.
