The Predictive Nature of Equities

Posted in: Economics, General, Stock Market, Thought of the Week

Paul Samuelson, one of the most well respected economists in modern history, once famously said:

                “Wall Street indexes predicted nine out of the last five recessions.

Sarcasm aside, this statement is quite intuitive because it drives home one of the most important concepts for investors to remember: The economy and the stock market are not the same.

Equity markets tend to predict economic downturns months before they occur because investors will typically sell stocks in anticipation of a move. In each of the last eleven recessions, stocks have dropped an average of 8% leading up to the start of every recession since World War II. On the flip side, stocks tend to move upward prior to the end of an economic downturn in anticipation of the return to future growth. In each of the last eleven recessions, stocks have increased by an average of 24% before the end of the recession. This is precisely why you simply cannot sit around and wait for the economy to get better when in the midst of a recession. Investors that wait to participate until the economy is fully recovered will miss out on much of the upside in equities.

Although equity markets are anticipatory, they are not always right. In fact, we’ve had thirteen instances of the DJIA selling off in excess of a 10% loss (correction) with no recession in the following twelve months. Additionally, the market falls an average of 20% every five years without the economy ever going into a recession. Although stocks are forward looking, they do not always see the economy through a clear lens. The reason for this inaccuracy is due to the emotional component to the stock market. Investors often have conflicting goals, time horizons, tolerances for risk and ability to control these emotions. Therefore, markets can move in directions that do not accurately represent the future path of our economy.

Equities are clearly anticipatory but they do not track the economy in lock step and are often wrong in their predictions. Our Investment Committee urges investors to keep three important principles in mind at all times:

  1. Look for Discrepancies: If fundamental analysis of the economy concludes that we will remain in an expansionary phase and stocks unexpectedly correct, take advantage of the emotional dysfunction in equity markets and buy into the weakness.
  2. Maintain a Long-Term View: Economies move in cycles but the long-term direction is up and to the right, and the same goes for equities.
  3. Never Attempt to Time the Market: Fundamental analysis cannot determine the direction of a market that is fueled by emotions. Those who attempt to predict the emotional ups and downs in equities are flat out gambling in a game where the odds are heavily tilted in favor of the house.

In summary, focus on the direction of the economy and not the day-to-day moves in equities because it’s impossible to fundamentally analyze emotions. Our Investment Committee sees very little risk of falling into a recession anytime soon and remains bullish on the long-term direction for equities.

Read this week’s Thought of the Week to learn more about the behavior of equity markets.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.