Can the Market Predict a Recession?

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Greg McFarlane

06 May, 2016

in Fundamental Analysis and 1 more

Can the market predict a recession? A “yes” answer might seem tautological on the surface, but isn’t. A recession is technically a reduction in economic activity, rather than in stock prices. Rephrasing the question a little, is it possible to have, whether in the long term or the short, an environment of low stock prices and high real income (along with high industrial production and employment)? To the first part, certainly not if the population at large is relying on stock appreciation for its remuneration. But given that wages and salaries still make up the bulk of most people’s personal income, a bear market shouldn’t affect said income by all that much.

Information, Not Opinions
The data isn’t hard to plot. Sustained reduction of growth (or negative growth, i.e. shrinkage) in real gross domestic product (GDP) over the last 4 years has no apparent correlation to movements in the Dow. For one thing, bear markets outnumber recessions. In the post war era there have been almost twice as many of the former as of the latter. Without any one-to-one-correspondence, it’s hard to draw a conclusive relationship between incidences of declining stock prices and of overall economic stagnation. For the same reason, kind of, full moons don’t predict tsunamis. The first occur too frequently, the second too rarely.

Horse Before the Cart
Of course, the longer a bear market lasts, the more likely it is that the prices of the stocks therein are undergoing a true correction and not a fleeting reduction. While we’re at it, the longer a bear market lasts, the greater the chance that stock prices were high - probably unsustainably high - in the first place.

If you’re looking for a legitimate predictor of recessions, the level of the Dow or the S&P 500 is no competition for the Treasury yield curve. When the yield curve is inverted, its shape representing that of an exponential function, that indicates that the return on short-term government debt is greater than that on long-term debt. The current yield curve (the Treasury Department updates it and makes it publicly visible daily) shows no signs of anything leading toward recession. When the yield curve says one thing and the market says another about the upcoming fortunes of the economy - housing starts, private sector hiring, etc. - you’re almost always going to be better off paying attention to the yield curve.

And To What End?
For the sake of argument, let’s say there was indeed a strong negative correlation between stock prices and overall economic vitality. And that correlation did imply causation. The almost guaranteed result is that there would be pressure - occupational, but mostly political - for the Federal Reserve Bank to take the step of trying to avoid avoidable recessions. Which would mean manipulating, or attempting to manipulate, stock prices. If you thought the Treasury Department had no problem finding justification for purchasing large equity positions in American International Group (AIG), General Motors Co. (GM) and Chrysler during the economic downturn of 2007-08, just wait until an aggressive secretary makes an argument for purchasing shares of even larger companies - Alphabet Inc. (GOOG), Apple Inc. (AAPL) and Exxon Mobil Corp. (XOM), for instance. The Treasury Department wouldn’t do this to direct company policies or choose winners and losers, mind you, but for the noble objective of balancing out the peaks and valleys and keeping growth in a band of manageable size.

Does that sound far fetched, and beyond the purview of a government entrusted with maintaining one of the world’s two largest economies? It oughtn’t, because China is doing that very thing as we speak. The Chinese government is becoming a market maker of sorts in the shares of several large companies. To be fair, one difference between the Chinese and United States governments is that the largest corporations on the Shanghai Stock Exchange are mostly Chinese state-owned enterprises anyway, with only a minority of shares available to private investors. It’s certainly conceivable that a similar thing could happen in the United States, especially seeing as it’s been done before.

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