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The Stock Market Isn't a Leading Indicator

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When it comes to recessions, the stock market is only good for hindsight.

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Inquiring minds are wondering if the stock market is a leading indicator. Consider the following charts:

S&P Monthly Chart 1980-1992

Click to enlarge


Vertical bars on the chart show when recessions began. There were three recession in this period -- starting January 1980, July 1981, and July 1990 -- according to National Bureau of Economic Research (NBER) Business Cycle Expansions and Contractions data. The NBER is the official determinant of recessions.

Looking at a chart of the S&P 500, it's difficult to suggest the stock market is a leading indicator, coincident perhaps but certainly not leading.

Moreover, the biggest decline during the period was a 35.9% drop in 1987, a period in which there was no recession. Furthermore, I circled four areas with very similar patterns in the 1980-92 time frame that were recessions following essentially sideways corrections in the S&P. Two of them were recessions, two were not.

For the 1981 recession and the 1990 recession, one could only tell there was a recession coming in hindsight. Finally, the January 1980 recession vs. the S&P 500 looks like noise. The stock market actually rose at the start of the recession.

S&P Monthly Chart 1998-2009

Click to enlarge


There were two recessions in the 1998-2009 time frame. The clearest case that the stock market is leading came in the recession that began in March 2001. However, the recession ended in November 2001, yet the stock market made a substantial new low mid-2002 with a double bottom test in Spring of 2003.

The stock market declined 34% after the recession was over. Is that a leading indicator? Of what?

For the recession that began in December 2007, the S&P 500 was down only a few percent from its all-time high. Is that a leading indicator?

Clearly the answer is no. The S&P 500 was a coincident indicator for the entire recession. The NBER hasn't yet declared the end of the recession, but it will do so and it will be backdated, most likely to Spring of 2009.

If so, the market will have proven to have been a coincident indicator, known only in hindsight.

Conclusion

The stock market is at best a coincident indicator, known only well after the fact. Furthermore, even as a coincident indicator, the stock market gives many false signals, making it totally useless for all practical purposes.

The theory that the stock market is a reliable leading indicator is a myth easily shattered by simple observation of the facts.

For more about leading indicators, please see Can We Really Trust The Leading Economic Indicators?

Have a great night!



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