Each and every weekday, untold millions of Americans learn whether the stock market rose or fell.
Indeed, the daily measure of what the stock market did may be the single most-quoted number thrown at us in this digit-saturated age. If you went through a week or so without hearing this number, you’d have to be living in a cave.
So important is the movement of the stock market that the Conference Board, which describes itself as “the world’s preeminent business membership and research organization,” has deemed it to be one of the 10 “leading indicators” of where the economy is heading.
Each month, the board’s data crunchers look at the direction of the Standard & Poor’s 500 index, which tracks the stocks of 500 large companies. They calculate which way and how much the S&P 500 and the other nine indicators have been shifting. Then they issue a press release, typically accorded vast respect and attention by the financial press, which describes the overall trend of the board’s “U.S. leading index.” This mother of all indexes sums up the direction of all 10 indicators bundled together.
Actually, the stock market frequently acts more like a misleading economic indicator.
What the record shows
“If one is looking for leading economic indicators, the stock market is surely not one of them,” Mike Shedlock, an investment adviser at Sitka Pacific Capital near Seattle, writes on his blog.
“I find it hard to believe that anyone thinks the stock market is a valid indicator of anything.”
Shedlock found that starting with the recession of 1960 and using a market decline of 10 percent as a leading indicator, the S&P 500 generated five false positives, one miss and one success. He wrote that:
• The S&P 500 didn’t decline 10 percent before, during or after the 1960 recession.
• At the start of the 1980 recession, the S&P was up year-over-year about 5 percent.
• When the 1982 double-dip recession began, it was up close to 30 percent.
• At the start of the 1991 recession, it was up more than 10 percent.
• As the 2001 recession began, it was nearly flat.
• In 1987 and 2003, the market fell nearly 20 percent, yet no recessions followed.
Other measures of market activity seem much more important than the S&P 500 in divining the future trajectory of the economy.
Martha Pomerantz is a principal at Minneapolis-based Lowry Hill, a wealth-management unit affiliated with Wells Fargo. Given the credit crunch that began last year, Pomerantz has been watching more closely measures of conditions in the credit markets. Recently, these yardsticks pointed, more or less accurately, to trouble ahead in the economy.
The stock market “predicts downturns far more often than they actually occur,” adds Louis Johnston, an economist at St. John’s University and the College of St. Benedict.
Johnston cites this enduring quip from famed economist Paul Samuelson, in 1966: “Wall Street indexes predicted nine out of the last five recessions.”
Market often irrational
Johnston calls the idea that changes in stock prices can forecast shifts in the economy an outmoded concept. He says the belief in the predictive power of the market was based on the idea that the stock market is efficient, but experience has shown that the market doesn’t operate that way.
Research by economist Robert Shiller and others has shown that herd-like market behavior — rushing into stocks when it’s fashionable and shunning them when it’s not; buying high and selling low — counts for far more than the efficient market theorists believed.
“They thought business cycles were like radio waves,” Johnston says. “It’s just not true.”
Johnston also notes that the S&P 500 excludes global grain-trading giants such as Cargill and entire sectors such as small business.
“The biggest problem is that the stock market is excessively volatile,” he says.
So the next time you hear that a big rise in the stock market means good times ahead, cool your jets. Similarly, when news of a sharp market decline resonates in the media echo chamber, don’t sing the blues. Tomorrow, stocks may well be heading in the opposite direction.