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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.
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Business Cycle Leads Equities

 
courtesy of Portfolio

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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.

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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 | Comments (44) | TrackBack (0)
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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