Tuesday, August 25, 2009

The Stock Market Is Not A Leading Indicator

The logic: "Since the stock market leads economic recoveries, once the stock market recovers, the economy will recover." That is, the stock market is a leading indicator.

I disagree.

I could've asked you
between mid-October 2008 - mid-January 2009, "What would you say is the current health of the economy?", you might've said something like, "Well, the stock market seems to have found a natural bottom around 8,500 (DJIA), so I think we've seen the worst of it, and so I'd expect a recovery in not too long once investor confidence returns in full." How would you explain then the following month and a half we spent below 8,000?

There's an inherent problem in using a stock market index both as a measure of economic health and as a future indicator of economic performance. Analogously, you need both a thermometer and a barometer to perform an analysis of the current environment and to create a forecast. The stock market has no foresight, it is purely reactionary, and so cannot be a barometer.

Why Any Index Sucks

What the Dow Jones Industrial Average Index (DJIA), for example, represents is an instantaneous assessment of investor demand for what the Dow Jones Company deems a representative sample of all publicly-traded companies on the New York Stock Exchange. When the DJIA goes up, the investor demand to own a percentage of those companies within the representative sample of publicly-traded companies goes up, and vice-versa when the DJIA goes down. In fact, it may be the only real world example of a
Giffen good. Leaving aside the validity of any non-statistically selected sample to accurately assess a whole market, we have to question whether the dynamics of that index are capable of capturing (1) the entire current economic state of affairs, and (2) the outlook for the future.

On (1), conceivably, the movement and value of an index, being a representation of investor willingness to own publicly-traded companies, would accurately reflect the overall state of the economy because those informed people buying up company assets in the form of shares would be reacting to a full set of up-to-date economic data, financial forecasts, industry surveys, and deep corporate analysis of assets and liabilities. The errors enter when you consider how inaccurate that full set of up-to-date information really is. E.g. No nation's central bank forecast this global recession. Alan Greenspan just shrugged his shoulders back in 2004. "A new paradigm!" Can you say the U.S. economy was actually strong 1.5 years ago when the DJIA was tickling 14,000? Or was it a facade of cheap capital that bloated the market's perception of those companies' value and led to our current situation? Even greater than inaccurate information is the investing feedback loop. A big mutual fund company dumps a load of cash into a company or industry, prompting others to do the same to catch the ride upward, prompting smaller investors to do the same and grab the sloppy seconds. All parties then unload their shares, in the process taking some good profit, to the latecomers who think they're onto the next hot stock. Did the value of the company ever actually change, or was it just the perception of the value of the company that controlled the stock value? Of course it was just the perception, and when you start attaching numbers (in this case, dollars) directly to people's perceptions, you get misinformation. For example, I'm an Orioles fan (as much as one can be anymore). Would I have put $10,000,000 on a bet at the beginning of the season that the Orioles would make the playoffs because their new pitching talent was being talked up on local sports radio? What if they're winning percentage in the first 20 games is .750? Doesn't sound like a bad bet, until you consider that the Orioles fucking suck and they have been hot early on but then collapsed at or before the All-Star break every year for the past 12. Anyway, the point is that gambling follows the same principle. You attach a value to your perception of the likelihood of the team you bet on winning, and your perception is based on imprecise information compounded with a dependency on the actions of individual people. The stock market is no different.

On (2), I think the obvious volatility caused by overreaction is enough to tank any stock market index's ability to forecast economic performance. Sure, whatever happens today may have residual effects in the future, but on the whole, it's merely a snapshot and an instant history. Looking at the artificial floor at ~8,000 in early February is enough to call this into question. You could point out that the market is back to about 9,500, but then I'd have to wonder why it ever bothered dropping 20% to 6,500 at all if it were a solid predictor of economic activity. It's not, and its value only tells you what other people just like you think it's worth. For that reason it is often considered a measure of investor confidence. This, I think, is true, but it doesn't really matter that much how confident investors are in the long-run. If all it took was confident coke-snorting traders on Wall Street then the DJIA would have gone into orbit by now; investors were mighty confident two years ago until they realized a lot of their money was tied up in things that weren't worth anything. That is, investor confidence is just a projection of past performance onto the future.

Why Weathermen Are Better At Their Jobs

The weather is a chaotic system. There are countless variables that influence it and there are countless attempts to do so. But despite its complexity, weather still follows the immutable laws of physics. The stock market, and for that matter, the economy, ultimately relies on a deeper chaos: human behavior.

What the stock market, or any index, really is is a forced amalgamation and an instantaneously fleeting assessment of what investors think of the value of traded companies, with no memory and no foresight. Simpler? It's an artificial grouping of what people think things are worth right now. Any attempt to derive much of a prediction from stock market data is doomed to fail eventually, because it's essentially a prediction of what people will do, and predicting people's behavior is, well, impossible, unless you work for Pixar.

Why I'm So Damn Right
Instead of breathing a sigh of relief watching the DJIA tick up-up-upwards, I'm rather concerned about the fact that unemployment---as measured by our screwy method---has increased by 62% since last July. If we're looking for a recovery, it's consumers, as always, that will drive it, and if there is less capacity for consumption, then there's less recovery. Less consumption and wages also means less tax revenue for federal and state governments, and the current government economic stimulus is not sustainable in the medium-term anyway.

I know people don't like thinking pessimistically, and for those without jobs it's particularly difficult to bear, and of course I hope I am wrong and the economy does turn around, but I think for financial analysts in the media and in the markets to continue to herd after the stock indexes is overly simplistic and will only lead to further calamity in the future.

1 comment:

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