Are Markets Leading or Lagging Indicators ?

Chicken or egg time.

Do markets lead because of the precognitive abilities of investors, or do markets lead because of the wealth that is either added or taken away?

Perhaps market prices are dictated more by interest rates and levels of leverage, and the ability for markets to “lead” is a result and not a prediction.

There’s a certain amount of emotional self-reinforcement in day-to-day bids. That, coupled with computer millisecond trading making up half of the daily volume means interpreting the stock market’s short term moves as having meaning is error-prone.

If the stock market, or anything, became a sure-fire indicator, it would stop being one. Such is the nature of markets.

I’ll take a shot for what it’s worth.

Prior to 1980, there was a banking regulation aptly named Ragulation Q. It was put in place in 1933 with the passage of Glass-Steagel and put limits on interest rates both charged by S%L’s and paid on demand deposits by banks. In effect they were interest rate controls.

Reg Q was a mighty weapon in the Feds toolbox. If in their opinion, the economy was too hot, they would dis-intermediate the banks. Once inventories were corrected or just prior to a recession, they would almost on cue re-intermediate. These actions were somewhat predictable and could in some measure be anticipated by the market.

The banking reform act of 1980 allowed the financial system many leeways that they enjoy (at their collective peril) today. The repeal of Glass Steagalin 1998 ushered in almost total decontrol of the system and lack of any self or authoritive discipline.

To answer the question, markets used to be somewhat anticipitory but no more.

Actually, I made an observation in 1971 about the ‘Presidential cycle’ and how our financial system was at that time subject to modest political manipulation. Times have changed.

Sorry for the tome. I need a life!

neither.

i think it’s just another extension of rational expectations/EMH /economists-are-oh-so-smart-that-we- can-predict-anything type nonsense.

markets just give a price for the present supply and demand conditions at any given moment.

commodities futures markets, on the other hand, are probably a better gauge. but only when taking backwardation (higher future demand) and contango (lower future demand) into consideration.

markets did a lousy job forecasting the housing debacle.

lurker,

I very much want to reinvest in China – long term growth prospects and a devalued Yuan that should appreciate 100% over the next 5 years. Am worried however that China’s efforts to quell inflation will result in equity valuations continuing to fall. Also I’m concerned with what appears to be an increasing level of central planning dictates into the market economy. Your thoughts?

The market is female. Barry, neither you nor I are ever going to figure it out-but we just might get lucky from time to time.

What you’re showing is a a result of what physical scientists refer to as a “hysteresis loop”.

Generally, if you graph the internal magnetization of a material against the external applied field as you first increase the field until the material is as magnetized as you can make it in one direction (“saturated”), and then decrease the field to zero and increase it to saturation in that opposite direction, you’ll not get a single curve — the internal magnetization vs. external magnetization on the way down is not the same as on the way up, and your graph will show a loop — a “hysteresis loop”. (This is why a screwdriver remains magnetized after you apply a magnetic field and then take it away.) And if you plotted the external and internal magnetization both versus time instead of each other, you would see something like the stock market graph.

Alas, much economic analysis assumes perfect reversibility — the absence of hysteresis.

“Here’s one last chart via Zubin Jelveh of Portfolio. Note that Consumer spending, GDP and Employment all peaked long before the October 2007 market highs.”
As ndallas points out that is an incorrect interpretation of those charts. It was the rate of growth that peaked prior to the stockmarket.

Hysteresis can also be a good thing. It keeps my thermostat within 3 degrees of where I set it…

Good stuff….
This is the reason I read this blog on regular basis. Excellent article & comments.

markets in the U.S. are rallying because short term interest rates are 1%..that’s when the last market started to rally in 2003…

Excellent post and in some ways better comments. Fruitful even where I don’t quite agree. Under Barry’s et.al. tutelage I’ve learned to think about markets having four major components: Structure, Fundamentals, Technicals and Sentiment. Each with a relevant timeframe. Over the very long-term structural factors determine economic growth and earnings, e.g Oil, Commodities and the supply-demand imbalances. Given a structure what determines l.t. market performance is earnings and valuations which is in turn based on profits and economic growth. Real earnings always revert to the l.t. growth rate and, when you look at the YOY% change charts, the markets tend to be codincident or lagging indicators. And have for decades (sorry Ross though that was a great post on systemic de-control). In the short-run technical factors dominate and in the very short-run emotional ones. Hence what I think is a bear-market sucker’s rally. I’d further argue that folks are seriously forgetting how early we are in this downturn and that earnings will lag. Oddly for an industry that’s supposed to be shot thru with analytic capabilities it doesn’t seem to do long-run modeling but instead extrapolates current situations into infinity and then adds Soros’ reflex in a feedback. Yikes !

Over the longer term, stock markets are a reasonable forward indicator of the economy. Over the short term, not so much. Much of the day to day or week to week action is driven by traders and fund managers looking for short term performance. Once a sector starts to move, the money will pile in for a while. If fundamentals don’t follow, the move falls apart.

When you see a large long term move like the one they’ve had in Chinese market, pay attention. It portends quite a slowdown ahead, both there and probably here in US, at least in discretionary spending.

Hasn’t the Fed done everything it could do to start an equities bubble? That is the last bubble left. I think that when the market rallies on news of 19 billion dollar mark downs, or news of 5 billion dollar mark downs, that one has to ask: isn’t this the classic response predicted by moral hazard theory? If the too big to fail principle is being applied with a broad brush, and the Fed has taken on the job of administering interest cuts in spite of a context of spiraling commodity prices and a falling dollar, then the market is responding rationally. Or perhaps I should say mechanically. If you take a measuring instrument – say, a gauge for air pressure and rearrange its components – for instance, disconnecting its dial face from the springs that are suppose to transmit the force of the air to the needle of the dial – it will no longer measure as it did before. This is pretty much what the Fed has been doing. The volatility, the inexplicable swings upward.

I don’t think equities will respond to the economic downturn for a while, because the Fed is doing all it can to prevent that response.

Many of the market concepts originated in a different era, under different circumstances – the market as a future discounting mechanism, for example, was believed back in the days when dividends were king and an increase in dividends was associated with a rise in stock price.

The modern market with emphasis on stock price as the return mechanism resembles more the commodities exchanges with shorter return periods are anticipated.

All that is being discounted is the lengths of the anticipated trades, which makes the market unreliable as an economic indicator.

Sorry, can’t resist at least posting one quote from the Soros speech I just linked to that relates directly to the current discussion:

“I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.”

Will Rahal,

I was referring to the last chart of Barry’s post. I started writing before you posted your comment, and so was unaware of it.

Here’s my theory.

Equities have a long-term upward bias and the normal state of the economy is to be in growth mode. Recessions are rare. So asset managers don’t want to sell “too soon”, even when they think a recession is more likely than not, because if they are wrong and a recession does not materialize, they will likely underperform their benchmark. The risk of underperforming creates an incentive to stay invested. That’s why I think equity prices do a lousy job anticipating recessions.

On the other hand, after equity prices have corrected to account for the recession, and knowing the long term bias is for higher prices, managers are eager to buy stocks at discounted prices. So they start coming back into equities long before the fundamentals have turned. If they wait too long, then once again they will surely underperform their benchmark. So equities do a great job of anticipating recoveries.

So in my opinion, the reason equities do a poor job of anticipating recessions but do good job of anticipating recoveries boils down to how asset managers are measured/compensated and the long term upward bias in prices.

It’s largely a question of “dumb money” versus “smart money”. The smart money gets in early, and properly anticipates the fundamentals of the future; the dumb money then gets in, thinking the current trend (whether up or down) is going to go on forever. And the REALLY smart money takes a short position at the top, selling the asset to some poor sap who gets burned in the end.

And actually the lead of equities is behind that of the bond market. At least on a downturn.

When, if at all, did SP500 earnings peak during the late 1990s? Broader, more economic NIPA measure of corp. profits peaked 3Q97, or about what would have been expected given the somewhat earlier profit slump in Asia, a slump which preceeded the financial crisis.

Share prices now seem to lag changes in economic profit, likely a consequence of what has become an overcapitalized system.

Larry, if the China reference had to do with my post, I’ll try to be more clear. The ‘Asian Crisis’ has been portrayed as currency crisis, hot money crisis, etc. but those doing so almost never take account of change in rate and mass of economic profit in, for example S Korea and Thailand well before the overt phase and its devaluations. That is, the most dynamic region of the world economy had begun evidencing weakness in advance of the market drops — same thing here in the U.S. but began slightly later and even as the indices continued to power higher and higher.

Not good for timing but was helpful as a ‘caution light’.