Bull Market Might Not Reflect Economic Reality

Why does the stock market seem bullish on the economy when other leading indicators are near a 19-month low?

Does it perceive something in the economic future not collectively seen by the other components of the Index of Leading Economic Indicators? Is its forecast right, or is it uniquely out of touch with events?

There is a tacit assumption, widely held, that the level of stock prices is a fair indicator of the future economy’s strength or weakness - that a strong market, for example, foretells a strong economy.

There are good reasons for such thinking because, it is reasoned, people aren’t inclined to risk their money for no good reason at all. It is one thing to make a prediction; it is another to bet your savings on it.

And that’s what millions of investors are doing, seemingly in defiance of important economic indicators that have turned bearish.

While few investors can reasonably expect stocks to perform as well as in 1995, when the Standard & Poor’s 500-stock index soared 35 percent, they haven’t taken their money and run. The averages remain high.

Meanwhile, the Index of Leading Economic Indicators hasn’t been doing well at all, having reached a 19-month low in November after declining for seven of 10 months. Such a performance is a classical sign of a weakening economy.

It is provoking a good deal of questioning. “Are millions of stock buyers mistaken,” asks economist Suzanne Rizzo? “Are the other 10 components of this index collectively off target?”

But equally difficult to ponder is the question of how so many investors could make such a massive miscalculation. Competitive stock prices, it should be noted, are believed to embody all relevant economic information.

Some of that information may pertain to specific companies and industries, but all such information is also considered in relation to the overall economy in which these companies and industries must operate.

You are justified in thinking, therefore, that the stock market is a good indicator of the future. Not quite. It has had plenty of failures, such as failing to signal the 1990-1991 recession until it was under way.

You might contend that the stock market wasn’t the only indicator that was a bit late in catching on to that recession; George Bush, the president, and Alan Greenspan, the Federal Reserve chairman, didn’t do much better.

But in a commentary for HSBC Securities, Rizzo recalls with devastating effect that the S&P 500 predicted 10 recessions in the past 34 years, only two of which actually occurred. That undermines the S&P 500 as a forecaster.

It does not, however, totally eliminate the stock market from consideration as an indicator. The S&P 500 is weighted toward the biggest companies, and thus might not be representative of the entire market.

Perhaps, Rizzo states, we might consider smaller company stocks as economic indicators, the logic being that smaller, younger concerns generally find it more difficult than big concerns to weather bad economic times.

The idea seems to have merit, since small company stock prices, as measured by the Russell 2000 index, deteriorated sharply relative to those of larger companies before the last recession. The index rose strongly last year, but has turned lower in 1996.

But if this concept is to be considered, it would seem also that another factor should be considered, that being the explosive growth of mutual and pension funds and the enormous flow of funds into their coffers.

They have to put those funds somewhere, and so long as interest rates remain low and relatively less attractive as investments those funds have become pillars under the stock market.

How firm? That’s another question.