Are Markets Leading or Lagging Indicators ?
Everyone "knows" that markets are leading -- not lagging -- indicators.
But are they really? It always gets stated so unequivocally that price contains information -- and I do not disagree with that belief.
However, I am not so sure it contains all the specific information that is often claimed. Indeed, we see short term market action used to bolster arguments in a terribly one-sided fashion all the time. When it goes this way, it is significant and meaningful; When it goes that way, well, not so much. It is a thesis applied inconsistently at best.
So are markets truly leading indicators?
I have a nuanced theory, and it goes something like this: There are so many varied inputs into equity markets -- sentiment, trend, liquidity, momentum, valuation -- anyone of which can be dominant at any given moment. Merely assuming markets are giving you a 6 month heads up into the future, based on recent action, is often unwarranted. There are simply too many examples where market prices are shown to be, oh, let's be generous and call it subject to misinterpretation.
Equity markets can and do provide some insight -- but they require careful interpretation, avoidance of broad generalities and oversimplifications. Unfortunately, that is often the stock in trade of many financial television shows and their T-head guests.
Let's take a look at some recent market action, and see what it might or might not be forecasting:
As the table above shows, this week saw US indices up between 4-5%. Many Bulls have seized on this as proof that the recession is now over, or will be soon enough. All clear! Its safe to get back in the water.
On the other side of the world, China's stock market has been cut in half over the past six months. Are their markets forecasting, as some Bears proclaim, that a worldwide economic slowdown is occurring?
Aren't these two beliefs rather inconsistent?
One of my favorite historical examples are the stocks of the Homebuilders. On their long, 75% decline, each and every rally attempt was seized on by housing bulls (usually parroting something Cramer said), proclaimed the bounce as proof positive that the Housing bottom was now in.
That turned out to be a very expensive misinterpretation of markets as a leading indicator.
Let's go back to the turn of the century: In late 2000, markets rallied right into the start of the recession; they sold off right into its end in October 2002 -- just as the recovery was beginning.
Here's one last chart, via Portfolio's Zubin Jelveh. Note that Consumer spending, GDP and Employment all peaked long before the October 2007 market highs.
>
Business Cycle Leads Equities
courtesy of Portfolio
>
So, are markets leading or lagging Indicators ?
My answer is that they can be both. But getting the correct interpretation involves careful review of the charts, sentiment reads, liquidity, momentum, market internals, and other data.
Insightful interpretation often yields clues, but is fraught with the possibility of error.
>
Previously:
The John McCain Market Selloff
http://bigpicture.typepad.com/comments/2008/03/the-john-mccain.html
Sources:
China Stocks, Once Frothy, Fall by Half In Six Months
JAMES T. AREDDY in Shanghai, CRAIG KARMIN in New York
WSJ, April 19, 2008
http://online.wsj.com/article/SB120856528917628111.html
Chart of the Day: The Business Cycle in Action
Zubin Jelveh
Portfolio, Mar 7 2008 12:59pm
http://www.portfolio.com/views/blogs/odd-numbers/2008/03/07/chart-of-the-day-the-business-cycle-in-action
Related:
Bloomberg TV has a special "China Focus Week” starting Monday, April 20th
Saturday, April 19, 2008 | 08:35 AM | Permalink
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Comments
How about this? Markets are markets and indicators are indicators! Predictions are tough, particularly when they are about the future...I don't think anyone is saying the recession is over because the market had a short-covering rally this week (okay a few morons maybe). It is really a question of depth and duration. We are going down (massive layoffs just getting going) but no one knows for how long or how bad it will get. Or how much of the globe goes down with us...we can argue all we want but NOBODY knows the future and all bets should be placed accordingly. The new highs list is packed with oil and oil service names, I will say that. And as for the Chinese market, isn't 50% a Fibonocci retracement point? Good luck and good trading to all.
Posted by: lurker | Apr 19, 2008 8:51:28 AM
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.
Posted by: bsneath | Apr 19, 2008 8:55:16 AM
It sounds dumb but could it just be that in the dearth of good investment alternatives (what with skyhigh commodities etc) funds have decided rather than twiddling thumbs they might as well take a chance on equities, after all, they have investors to please and ultimately interest rates to pay (aassuming they had leverage)
Posted by: Judy | Apr 19, 2008 8:55:35 AM
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.
Posted by: VennData | Apr 19, 2008 9:16:45 AM
Venn just said it better. drats. thanks VD!
Posted by: lurker | Apr 19, 2008 9:19:02 AM
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!
Posted by: Ross | Apr 19, 2008 9:20:34 AM
Actually, the rate of growth of consumer spending, GDP, and employment peaked prior to 07, not the actual levels. Hence, the decline in equities since late 07 may still be a valid leading indicator for declines in the level of economic activity. Is the current rally is an indicator of recovery or merely a fluctuation? ...too soon to tell.
Posted by: ndallasj | Apr 19, 2008 9:34:31 AM
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.
Posted by: m3 | Apr 19, 2008 9:34:42 AM
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.
bingo.
when bernanke cuts interest rates on options expiration, and the dow screams higher, how would that be classified? lagging? leading? or market manipulation?
rate cuts = more leverage = higher prices != economic forecasting.
Posted by: m3 | Apr 19, 2008 9:40:54 AM
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?
Posted by: bsneath | Apr 19, 2008 9:49:56 AM
my thoughts? I have plenty, but they always seem to lose me money. I was commenting on the chart only as I do not think anyone can predict what the Chinese will do (investors or their government). Please do not take my advice as my opinion means nothing to the market. I was just making a comment about the chart and I do NOT trade so my opinion is even less valuable. Best of luck to you and always trail a stop in case you are wrong....but thanks for asking!
Posted by: lurker | Apr 19, 2008 10:16:03 AM
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.
Posted by: Rich Shinnick | Apr 19, 2008 10:28:59 AM
Typically Markets lead.
It is still very tricky to determine if a reversal in the real economy is to be expected with reversals in the markets, since markets have periodic corrections and tend to go to extremes.
Talking about extremes, I expect an imminent
correction in commodity prices.
I have posted charts on the relative performance of PPI components such as Finished Goods, Intermediate & Crude Materials.
We have reached historically extreme levels
which in the past were associated with reversals.
See
http://wrahal.blogspot.com/2008/04/stretched-to-limit.html
Posted by: Will Rahal | Apr 19, 2008 11:10:01 AM
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.
Posted by: jm | Apr 19, 2008 11:24:51 AM
Jim,
Are you referring to my charts?
Posted by: Will Rahal | Apr 19, 2008 11:39:36 AM
"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.
Posted by: tyoung | Apr 19, 2008 11:42:25 AM
This is off topic, but I'm noticing less doom and gloom in the TBP comments lately.
Is the bearfest waning? Perhaps BR's postings are directing his readership to more academic subject matter?
Less schadenfreude certainly.
Posted by: Emmett | Apr 19, 2008 11:45:57 AM
Hysteresis can also be a good thing. It keeps my thermostat within 3 degrees of where I set it...
Posted by: Ross | Apr 19, 2008 11:46:17 AM
Let me start by saying I read this blog everyday because it does a good job at the immediate Big Picture. I think the question is too narrow....or at least needs to be re-framed somehow.
I was schooled in marketing and found the general perspective narrow on behavior. Then I found (pro)traders had a much better perspective of the daily supply/demand/participation dynamics to understand ebbs and flows in markets.
I suspect any market where people trade anything have important behavioral themes no matter how efficient they are. We read about speculation like this everyday in whatever business you are in but to get a solid bigger sense of it is hard. If you are willing to take a chance and step really far back and just look at it all as behavior, not of individuals but if groups in big chunked up periods of time act in coordinated ways...well by that time you are so far from financial markets it seems like 'how could those long term perspectives have anything to do with fin. markets?' If you are willing to do this you would do well to read (among other authors) one of Prechter's books that doesn't talk about scary crashes. The Elliott wave principle is a great tool till you use it to create big expectations. It offers an excellent perspective of humans in markets in general and then when you do begin to get back into the "math" of market participation (short term stuff) you can see that quant traders understand how we behave in groups, and how in groups, we can be seen to behave in recognizable patterns but also in ways that offer better-than-random probabilities to the future. If markets were truly efficient trading would have never become as large a profession as it has, right? Trends are how humans operate in groups. George Soros struggled to explain part of this lately. Just don't expect that realization will be worth anything but a small edge on occasion to put on a trade. Dr. Brett Steenbarger has a really good perspective on the short term stuff. From the largest perspective, yes markets lead...but that and $2 gets you on the subway.
Posted by: DaveM | Apr 19, 2008 11:50:23 AM
Good stuff....
This is the reason I read this blog on regular basis. Excellent article & comments.
Posted by: Sri | Apr 19, 2008 12:04:03 PM
Rich Shinnick wrote:
"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."
Rick, you nailed it!! (I mean... you described it perfectly. Sorry. That was hilarious!!)
Barry, it's been a hellava week. Really enjoyed all that you put up on the blog. Keep it coming man.
Posted by: BG | Apr 19, 2008 12:04:58 PM
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...
Posted by: jake | Apr 19, 2008 12:23:26 PM
When has a bubble ever not burst?. So is a market going up in a bubble an indicator of better times ahead or of a certain bust ahead? It all depends on the time frame no?
Posted by: Bob A | Apr 19, 2008 12:33:48 PM
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 !
Posted by: dblwyo | Apr 19, 2008 1:16:43 PM
For a long while during the market peaks I saw markets as the store of inflation. Then the inflation moved into housing, now it is in commodities, driving up our food and energy prices.
There is too much money out there, in the hands of too few, looking for too high a return. The markets are distorted by the game playing. The information they once contained is hidden under a layer of fat.
Posted by: donna | Apr 19, 2008 1:19:53 PM
