Does the stock market predict things to come, or does it reflect things passed? Believe it or not, the answer is quite intuitive and simple. Stranger than that is that many financial planners, economists business leaders and stock analysts have it wrong. The answer is unavoidably that the stock market trails movement in the real economy.
How can this be? Everyday on the financial news it is taken as a given that the stock market is a predictor of the future of the economy and quite efficient in doing it. Such sources also tell us that the stock market is an efficient mechanism that reflects the true price of an asset or company based on the compilation of large sampling of peoples' opinions. Books such as The Wisdom of Crowds, by James Suroweiki, further state that large sample sizes of random guesses tend to better predict an unknown (such as an asset value or stock price) than an individual. Further, this school of thought has run a number of controlled tests that proved that a large sample size of random guesses is better at predicting an unknown than a small number of better equipped individuals (smarter or more experienced) who are collaborating to formulate a guess.
The fundamental premise is that information provided must be equal to all guessing.
It is a very small jump from this conclusion to state that markets best reflect the true value of an asset or company so long as information is freely available. People from this school of thought are most commonly referred to as Efficient Market Theorists (EMTs). Business programs predominately teach this method of market valuation to MBA students and the majority of players on the scene believe this to be true. So, if assuming EMT is correct, how can the market be a trailing indicator? Wouldn't it be a good predictor of the future?
Unfortunately not. The precipitous decline in the stock market in the fall of 2008 was clearly a reflection of the steady decline in the American economy beginning in the middle of 2007. The economy was sputtering in 2007, and financial analysts told the public nothing was wrong, and that if one separated the durables, autos, homes and mortgage business from the remainder of the economy everything was just fine. That was an incredible statement, and a terrible misrepresentation. It is common knowledge that durables, autos, and homes are the first indicator of a recession and as soon as they show declines, the entire economy shall follow. In fact, Alan Greenspan's company, prior to him becoming Federal Reserve Chairman, used to predict business cycles by simply tracking durables and automobile sales. That said, financial analysts, newscasters and government officials insisted that this was a "new" economy and such variables were no longer dispositive. Wrong. Funny how Greenspan, in his eighties nonetheless, predicted the recession within weeks.
The stock market continued on its upward trend throughout 2007 despite all prudent economists understanding a full blown recession would hit before the end of the year. Why was the market not reacting? The answer: denial and data.
1. Data
The first reason why the stock market is unable to predict future movements in the economy is that the prices are set by the purchase and sale of equities by analysts who base their decisions on data now known. The imperative here is that the prices are dependant on the reporting by companies of events that have already happened. Earnings, estimates and strategies released by companies are always released well after they have occurred. In other words, analysts, financial reporters, and traders receive data that has been processed by Board of Directors and executives for days, weeks and months. Therefore, it is an incontrovertible fact that stock prices trail real economic events. This reality is multiplied tenfold when the economy is recessing as companies will use deferrals and reserved profits from past expansions to buffer evidence of a slowdown in their business. The result, analysts and buyers are even further behind the curve of a bear market.
It is important to note that it isn't only business data that is slow to market, government data is painfully slow to market. One great example is jobless claims. First, one must admit that reducing capacity is one of the last cuts a business is to make. In most cases, businesses will begin cutting all areas that don't directly affect their ability to produce. As a result, necessary job cuts often come well too late in the business cycle as businesses must be sure demand won't rebound before diminishing capacity in the work force. The point is that the real economy has shifted and the financial news channels, traders, analysts and economists cannot see the shift. In other words, the government reports, which traders rely on to trade and invariably derive some picture of the future are more analogous to the wake than the boat.
In addition to equity reports and government reports lagging economic realities, commodity reports must be the least reliable of the bunch. A great example is OPEC. Cheating, overproducing and general market manipulation have created an environment where analysts and traders no longer trust forward announcements of OPEC. Analysts don't believe OPEC when they declare they will produce more oil to keep prices tolerable and they don't believe OPEC can restrain from producing at lower prices despite promises to do so to increase prices.
The net result is analysts, financial networks, and traders basing future decisions on inventory reports from the past. Worse yet, these reports are incapable of determining whether reserved supplies increased or decreased due to demand or supply. Regardless, players in this game determine how to bet based changes in the past.
In all fairness, I must state that many efficient market theorists would argue that traders, analysts and economists don't believe they are guessing at a future valuation of a company, but rather using the data to generate a prediction as to the present value of the company in real time. If that is the case, then the stock market is neither a trailing indicator or a leading indicator of the economy, but rather a barometer of the economy in that exact moment. That said, the general tendency of the market to wait for trends to emerge and the complimentary tendency to hesitate before declaring a change of trend leads to a conclusion that the stock market isn't even an efficient indicator of the current market.
2. Denial
The second reason why the stock market and asset prices always lag reality is because of momentum, or as I like to call it denial. Humans are creatures of habit. When things have been trending downward, people cannot imagine what it was like when things were growing. Vice-versa, when things are growing people cannot imagine a reversal as the common tendency is to believe "things are fundamentally different this time(commodity bubble, tech bubble, housing bubble, and soon to be the end of health care bubble)." As a result, analysts, brokers, traders and economists wait for a trend to emerge before declaring it safe to change direction.
That's right! Not only are these market participants basing decisions off of old data, once they see data signaling a change, such data is earmarked as an "aberration" until it duplicates itself. In the clearest sense people literally wait to buy once the real economics have turned more favorable and usually do so six to eight months after the company has realized the change in business.
The funniest part is that once the decision to purchase or sell is made, the real run of expansion or recession is well underway indicating that the reversal of that trend is closer than the market participants realize. As the price moves because of these transactions, it attracts more transactions in the same direction which most closely can be analogized to a stampede. This stampede always overshoots its target as the participants are watching old data and waiting in denial for trends. This creates the wild inefficiencies of markets in the short run, and also illuminates why 95% of the investing public ends up wrong all the time.
While I'm certain it is human nature to buy high and sell low because its the popular thing to do, its comical how we fear to act when the opportunity costs are low (prices are low because the majority are predicting further wealth destruction) and are so brave to act when the opposite is true. When the trend of past data is upward, indicative of a bull market, we as investors love to run directly off a cliff. Reminiscent of the old roadrunner cartoon, standing on nothing but air and filled with a false confidence by the reported data we believe to be a reliable prophecy of the future, there is no where to go but down.
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Love it dude, make sure you do more political themed blogs though!
ReplyDeleteTrev, screw the politics! Let's talk more market. Very valid points but I still can't buy into the fact that one indicates the future/past or vice versa. You state "The precipitous decline in the stock market in the fall of 2008 was clearly a reflection of the steady decline in the American economy beginning in the middle of 2007. The economy was sputtering in 2007, and financial analysts told the public nothing was wrong, and that if one separated the durables, autos, homes and mortgage business from the remainder of the economy everything was just fine." Well everything was just fine ceterus paribus(to wall street just like it was to the american public in early 2007) but what wall street didn't get is that they were merely the next in line to drink the "Jim Jones Punch"(credit, or lack there of) that the american consumer had been drinking since the begining of 1999. I don't believe that you can assign any correlation to the two markets that you are referring to. I do think that your arguement happens to be correct in this time frame however it does not address the effect of credit availability and time frame for both "markets". The obvious distorting factor in this analogy is the use and availibility of credit and how it distorted both the "economy" and the "stock market" Use of ridiculous leverage became available to both at different times. From 1999 to 2006 the "economy"(and let's face it the "consumer" as we might as well say in this country") had an abundance of easy credit which distorted and magnified assett prices, it was this magnification of asset prices that allowed wall street the resources to lend outrageous sums of money to "investors" levered up some 40 times. I guess what I am trying to argue is that if someone were to have "magic glasses" and could see the "real econmy" and see through all of the effects that credit had and the roles that it played in both of these bubbles, you could see the "real" demmand for these assests and price accordingly. Conversely didn't the stock market lead with the dot com bubble and "predict" the housing bubble? After all is was 700,000 studio apartments in San Jose that started the creative finacing boom. I guess we can all be right it just depends on the time frame we choose to highlight. I do belive that your argument for this one though happens to be spot on.(If you look at this time frame in a bubble....no pun intended)
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