(Ronald Chan is the Founder and CEO of Chartwell Capital, an asset management company based in Hong Kong. The views expressed in this column are his own and do not represent those of Reuters)
By Ronald Chan
We have entered a period of financial market mix and match. As we read through the news headlines in the paper or on the Internet, we see heavily mixed comments about what lies ahead for the economy.
For example, according to an Organisation for Economic Cooperation and Development assessment in early October, the world economy appears to be slowing down, as its economic activity indicator fell for the second straight month.
Reading the next headline, however, we find financial journalists telling investors not to worry because the global stock market will continue to rally. Their assessment is based on widespread speculation that the Federal Reserve will take further action to stimulate growth, thus driving up demand for both commodities and stocks.
Then we read: “Jobs stink, but Dow surges. What’s up?”
This is followed by economic analysis from a bank, which predicts the U.S. economy to be “fairly bad” over the next six to nine months, with a thirty percent chance of a recession.
Just as this news begins to cause us alarm, another article pops up. A major investment bank is now encouraging investors to purchase stocks with the highest P/E ratios because their valuation premiums are rather low by historical standards.
Scratching our collective heads over the mixed signals that all of these headlines convey, an alternative market predictor appears: the Hemline Index.
As alternative as it may sound, the Hemline Index was actually introduced by economist George Taylor in the 1920s. According to Taylor, the hemlines in women’s fashion reflect economic sentiment.
When hemlines go up -- think mini-skirts -- the economy looks rosy and everyone is optimistic. When hemlines go down -- think long dresses -- the economy looks uncertain and gloominess prevails.
Although this indicator seems absurd, it actually works.
For example, fashion designers called for hemlines just below the knee in the early 2000s, suggesting conservatism. Then, hemlines gradually crept up, reaching the mini-skirt level in 2007. Just before the financial crisis hit in 2008, coincidentally (or not?), designers showcased full-length dresses for the coming season, thus expressing maximum pessimism about what lay ahead.
In mid-2009 and the early part of 2010, short shorts and mini-skirts were back in fashion, and so was the economy and the major stock markets.
Now, looking forward to 2011, fashion designers, appropriately enough, are giving us mixed signals.
In the most recent fashion shows in Europe, designers have featured both long and short hemlines, with the trend favouring slightly longer hemlines that fall around or just below the knee.
“I felt the play on very short and very long pronounced the statement,” said one fashion designer. “I even showed some maxi-length gowns, with a mini-skirt lining, to pronounce the aesthetic dichotomy between the two.”
If this fashion trend contains any hint about the economy, does it imply that we should be “cautiously optimistic” about what lies ahead?
With the market gaining upward momentum, it shrugs off negative news items and cherry-picks positive ones. In fact, the major stock markets have seen double-digit growth in the third quarter of this year.
At the moment, the forward P/E of the Dow in the U.S. is trading at 12x, the Hang Seng Index in Hong Kong at 14x, and the FTSE in the UK at 10x.
Whereas some believe that the market is trading at a fair level, others fear that the upward momentum is forming a new bubble.
In light of the hemline effect, perhaps the implication is that the economy is bad but the stock market is good. Thus, even if a bubble is indeed forming, the fair valuations of the market indices suggest that we are probably in the first round of a game of musical chairs.
(You can e-mail Ronald Chan at firstname.lastname@example.org)