Lagging indicators are called lagging indicators … for a reason.
As I have been perusing the ol’ ‘interwebs’ as of late, I have noticed that trader, after economist, after commentator has been pointing to an expansion in economic activity in the United States, and why we ‘don’t really need to pay attention to valuations’ due to expansive growth in the U.S. economy.
Now, to be sure? The underlying assumptions and variables to any valuation model, from intrinsic to relative value, can change. And therefore what was ‘overvalued’, without much dip in the nominal price, can transform into ‘fair value’, or even ‘undervalued’.
Regardless, getting back to my point. I thought this week it might be useful to remind ourselves why lagging indicators … are called lagging indicators.
By definition, many such metrics … be they corporate profits, GDP, or headline unemployment rates … are metrics that look into the past. And as such, they cannot tell us how a complex, chaotic future will actually unfold.
One History Lesson of Many
In the months leading up to the 2008 financial crisis, the dominant economic indicators told a comforting story.
Growth was slowing … but still positive. Unemployment was rising … but not alarming. Corporate earnings were weakening … but far from catastrophic. And best of all? Equity Valuations still appeared quite attractive to overall earnings. One could have made an argument that the overall market to some extent was still somewhat undervalued.
Unemployment Rate up to May of 2008
“The Buffett Indicator” up to May of 2008
(Total US Stock Market Cap to GDP Ratio)
By the standard macroeconomic scorecards relied upon by economists, policymakers, and investors, the U.S. economy in early to mid-2008 appeared bruised … but intact. Mid-cycle. But still growing.
And then, all at once … it wasn’t.
This disconnect between what the data suggested and what ultimately occurred is not a historical curiosity. 2008 is not a ‘one off statistical outlier’. It is a structural feature of financial crises. In hindsight, it’s quite easy to watch ‘The Big Short’ and laugh at those ‘blindly unaware’ as to what was about to occur. The problem is that the tools most commonly used to assess “economic health” are largely blind to the mechanisms that actually cause systemic failure.
The problem was not economic activity. The problem was balance sheets.
In 2008, vast portions of the financial system were built on opaque assets tied to a linear risk modeling assessment. As long as confidence held, the machine ran smoothly. When confidence wavered and the ‘players at the table’ began to question their counter-party risk? It was too late. The world was already over-leveraged 120:1.
GDP didn’t register it. GDP couldn’t register this. None of this showed up in employment reports. None of this showed up in output figures.
This led to my particular mantra when examining promising, econometric data: “everything is great … until it isn’t”. Which is simply an acknowledgment of the understanding that lagging traditional economic indicators will always fail at massive turning points.
They have to. They are lagging by design.
Employment falls after demand collapses. Earnings decline after funding dries up. GDP contracts after balance sheets have already been impaired. By the time these indicators flash red … the crisis is no longer approaching. It has already arrived.
Just … Be Aware
We have long maintained that equity markets appear meaningfully overvalued. That view isn’t based on a single data point, nor on short-term economic momentum, but on a collection of structural considerations that guide how we manage portfolios.
That said, we readily acknowledge a simple truth. No one knows what the future holds.
The assumptions contained within any valuation framework, whether intrinsic or relative, are not static. They evolve. And as those inputs change? Valuations can adjust without requiring a decline in nominal prices. What appears overvalued today can, over time, become fairly valued through growth in earnings, cash flows, or broader economic capacity.
Put more formally, markets can grow into their valuations.
This possibility should not be dismissed. But neither should it be assumed.
The difficulty, as history repeatedly demonstrates, is that lagging econometric data often reinforces confidence precisely when valuations are most stretched. Growth may appear durable. Employment may remain resilient. Yet those signals are describing where the economy has been … not where it is going.
We do not claim to know how this resolves.
But when optimistic economic data is weighed against stretched valuations, it is worth remembering a lesson markets relearn repeatedly.
Everything is great … until it isn’t.
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