Can the market predict upcoming Up\Down turns?

Equity markets are anticipatory, meaning they often predict an economic upturn or downturn months before one occurs because investors will buy or sell stocks in anticipation of a move.

The Dow Jones Industrial Average (DJIA) is a popular stock index in the U.S. and it has predicted the last eleven recessions as well as each economic expansion coming out of these downturns.

The DJIA also falls an average of 20% every five years without the economy ever going into a recession, so there are times when the economy and the stock market are out of tune. Equity Markets Anticipate Change. 

The worst periods for investment returns have clustered around major economic downturns such as the Great Depression, the high inflationary 1970’s, and most recently the Great Recession in 2008.

Equity markets tend to predict these economic downturns months before they occur because investors will typically sell stocks in anticipation of a move.

The data in Bloomberg published charts support this notion.

The performance of the Dow Jones Industrial Average (DJIA) Index prior to each of the last eleven recessions. 

It shows that stocks dropped an average of 8% leading up to the start of every recession since World War II, so it does appear that investors correctly anticipated an economic downturn prior to its arrival.

On the flip side, stocks also tend to move upward prior to the end of an economic downturn in anticipation of the return to future growth.

The data shows that stocks increased by an average of 24% before the end of the last eleven recessions. 

Just as the DJIA predicted every recession since World War II, the index also rallied prior to each upturn.

But 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.

Equity Markets Aren’t Always Right!

Although equity markets are anticipatory, they are not always right.

In fact, the data shows that we’ve had thirteen instances of the DJIA selling off in excess of a 10% loss (commonly referred to as a “correction” on Wall Street) with no recession in the following twelve months:

It also shows that 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 such inaccuracy is due to the emotional component to the stock market.

Participants 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. Implications for Investors.

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, and that is the economy and the stock market are not the same.

This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. 

From an article by Mike Sorrentino, CFA Chief Strategist, Aviance Capital Management

Global Financial Private Capital is an SEC Registered Investment Adviser.

Data quoted from charts courtesy of Bloomberg.