Thursday, June 04, 2009

Does the stock market predict economic recoveries?

"The stock market predicted 10 of the last 6 recoveries" - George Soros.
I wanted to write about this but Mr. Wang beat me to it[here] and The Singaporean Skeptic[link] wrote a short and useful explanation using Baysian Inference. The short answer from my experience is almost every economic recovery is preceded by a market rally but not every rally is followed by an economic recovery and when the economic recovery does not come, the market simply goes back down. But lets go a bit further than this short answer.....

Take 1929 as an example:

The market rebounded sharply with a 50% rally in 1930 only to see a 3 year bear market. Market technicians will tell you that the DOW rebound to touch the 200 moving average but fail to cross it to confirm a bull market (I'll talk about the significance of this notion later).

In Sept 2001 the stock market had been falling for about 18 months since the bust and appeared to have stabilised. Unfortunately due to the 911 terrorist attacks, the market fell through its bottom. Many contrarian investors felt at that time that the worst of the worst had happened and the market rallied for six months from Sep 2001 to March 2002 only to fall to new lows in late 2002 when the economic recovery did not meet investors' expectations.

George Soros once explained that while stock markets may not be reliable predictors of the real economy, you can actually get market downturn that is so bad that it causes a recession. If all of us. around the world,believe the recession is going to be over soon and we go out to buy some stocks, look for property and take part in the Great Singapore Sale, we can actually take the global economy out of the doldrums. There is a complex relationship between the market and the economy. When the stock market rises, it helps the economy because companies can raise money by doing cash calls in the stock market to ease their cashflow problems or do acquisitions. If the stock market or property market rises high enough, consumers will regain confidence and start spending. In other words, when markets have large moves, they actually start influencing the real economy which they are suppose to predict. George Soros decribes this interaction in his Theory of Reflexivity [see speech to MIT Department of Economics]. .

So how much must markets rise before you know if a rally is for real or a fake? Many technicians believe the 1930 rally failed because the market did stay above the 200 day moving average. I'm a complete skeptic of most of what is known as technical analysis because they create all these indicators without the supporting evidence that they are accurate. But lets take 200 as a rule of thumb and the fact that when market indices are above the 200 day MA means that stocks are above the average buying price of the past 200 days - that might create some wealth effect and confidence from Soros' Theory of Reflexivity. The S&P500 and the DOW Jones Index(?) crossed the 200 day MA on Monday and the traders on CNBC were all very excited over this "confirmation" of the bull market. If you take out the chart of the Dow or S&P and put in the 200 day MA, this crossing of 200 day MA did market signal the start of many major bull markets. However, there were also periods when the index crossed it and did nothing for a few months - again the theory is not perfect and you can't bet your whole lifesavings on it.

One thing is certain - if the economy does not meet the rising expectations of investors, the selloff come really 2002, the market give up all the gains of a 6 months rally within 2 fell 3 times faster than it rose. make money you really had to get out faster than you got in....


Anonymous said...

Obviously it is a myth.
However, if enough people believe in it then it does not matter.

TA is a tool based on observation of human behaviors. Folks like Mr Wang would have timely and accurate info. IB makes the market. Folks like ur mob do not. So relying on TA is one way to react quickly to Mr Market.

Btw, USA is not SG. Dow not STI. We could go on and on but that would bore ur readers.

How about u just issue buy and sell calls?

Lim Leng Hiong said...

Crystal-clear article. Thanks Lucky!

To Anon 2:08,

"However, if enough people believe in it then it does not matter."

I'm not an economist. Can you please explain how technical analysis can show us if "enough" people believe in the rally?

Anonymous said...

Actually I was refering to "Does the stock market predict economic recoveries?"

however, if the market goes up on high volume and since these days many "traders" actually trade using preset signals (automated) prescribed by the same widely read textbooks, it would be self fulfilling. It is seriously boring.

Lucky, on the other hand, is a experience and successful investor. since we are, after all simply followers, and his calls would do nicely too.

Anonymous said...

The market is fragile, everybody will cash out at the slightest negative sentiment, eg a shots fired across the DMZ in Korea, discovery of B variant of H1N1, collapse of Citibank, etc

Anonymous said...

GM filed for bankruptcy.

Obama said "We're out of money".

These alone speak "volumes" about economic "recovery".

When something is too good to be true, there is a catch somewhere.

Konsultan Statistik said...

Great article.
In indonesia, stock market were very good in 2007 but very bad in 2008. In 2009, recently, performance indonesian stock market, represented by composite index are very good. But tomorrow???? who know

best regard

Lim Leng Hiong said...

To Anon 3:04,

"Actually I was refering to "Does the stock market predict economic recoveries?""

Sorry, I don't really understand what you mean, I thought you said that "if enough people believe in it then it does not matter", which indicates that you have some way of knowing (using TA?) how many people believe in it and how many people is "enough" for a stock market rally to become predictive of economic recovery.

Anonymous said...

Great post, Mr Tan! Thanks.

I agree with your explanations, except that we all get tempted to jump on the rally because there can be some real money to be made. In the same breath, it's true that we can lose some very real hard-earned cash too. So, moral of the story is still - step into the stock markets with both feet on the ground, and eyes wide open.

Thanks again for the insightful post. Cheers

DanielXX said...

If you examine the charts for various indices, you will find that the Western markets' indices like US & UK are not clear of their 200 dma while Asian markets like SG and HK have broken convincingly above. Indices, of course, are just an indication but if you follow the Singapore market you will surmise that the recovery is broad-based across both blue-chips and small-caps. In this sense the technical indicators have been pretty logical, since Asian economies are better positioned than Western markets for a recovery. The broad-based participation also suggests that we should take suggestions of recovery with more than a pinch of salt.

Soros cannot quantify reflexivity and hence his theory can only remain as a hypothesis/conjecture. But it is very true in its essence. Asset prices define the wealth effect, which together with income and debt borrowing, form the three main pillars for expenditure funding. Stable asset prices also stabilise collateral and prevent vicious downward cycles of forced selling.

Anonymous said...

i rember one mentor having said that this recovery will not be a v shaped but rather a u or w.

i think having seen his predictions on oil prices and the directions of the stock market various times, his track record stuns. better listen to him. we have an alvin toffler in our midst and he is paid to gaze at the stars.

oh another thing, the mentor predicted that china will be a great nation, so listen up. as strange as it may sound, this thing even the kids also know. how come arh?

Anonymous said...

Obama is "out of money", but Lee Kuan Yew is giving away free money to Bank of America and Bayclays, right?

How much? 5 Billions to BoA and 1 Billion to Bayclays.
Guess how much will he give Citigroup?

How much will he give pathetic NS Slaves, eh?

Anonymous said...

sad. Why loss so much money?
Why kept losing money?
who is in charge?

Anonymous said...

Dear Mr Lim

And u are one of the reason why I feel Mr Lucky Tan should just give buy/sell calls.

No offense but simply its a topic beyond maybe 95-99% of singaporeans (and probably 80% of his regular readers who are slightly more educated). Lucky is a gifted writer and successful investor but like most MPs do not understand the lesser mortals.

Lim Leng Hiong said...

Anon 8:52,

"And u are one of the reason why I feel Mr Lucky Tan should just give buy/sell calls."

But I have no money to invest in the stock market, so I don't know what you mean.

"No offense but simply its a topic beyond maybe 95-99% of singaporeans (and probably 80% of his regular readers who are slightly more educated). Lucky is a gifted writer and successful investor but like most MPs do not understand the lesser mortals."

Maybe so, but I find your comments to be unclear and cryptic. DanielXX's comment is more helpful, he explains how Lucky's view could be too cautious.

Perhaps you are saying some insider speak to Lucky?

How I wish somebody would actually answer my question, sigh.

I must be stupid said...

Hi LH,

I think what anon means is that the stock market works like this: If enough people believe that the stock market is going to rise they will be able to move the markets by buying all at the same time. The resulting effect is that people feel richer, consumers become more confident and start spending more, eventually leading to the end of the recession. It's essentially a self-fufilling prophecy.

On the topic of TA, Warren Buffett says it best "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer". LOL

Lim Leng Hiong said...

Thanks IMBS!

wheregotfree said...

I hope it will recover soon enough. Want to recover my money to buy flat

Anonymous said...

"If enough people believe that the stock market is going to rise they will be able to move the markets by buying all at the same time."

With $$$ billions or trillions already bleeding out of the global system. Now where to get the money onto the right number of people to finance these beliefs.

Only borrowing from those who have it and may be holding it maybe because they know better and printing money will work, with their own set of other consequences.

Lastly, the up and down of the stock market sometimes has nothing to do with the underlying fundamentals of corporates and so beliefs again may be misplaced, the lesson which this present crisis has taught us.