Does The Stock Market Follow The Business Cycle?

"Looking ahead, we're facing a broad based slowdown in economic growth, but have plenty of room to slow without slipping into recession"

By Lakshman Achuthan
(This is one in a series of occasional opinion columns by market participants.)

NEW YORK (Dow Jones: 3-November-2007)--Last February, U.S. stocks suffered their worst one-day loss since September 2001, prompted by a major sell-off in Chinese stocks, higher oil prices and concern about housing and subprime lending. The drop in stock prices was blamed in part on former Fed chairman Alan Greenspan's assessment of a one-third probability of a U.S. recession this year.

Since then we've seen a considerable rise in recession probability banter. But when someone says they see a 50% chance of recession aren't they simply saying they're clueless about whether a recession is likely? A coin flip would be just as useful. Is there any objective evidence to support this recession fear? And to what extent are stock price downturns linked to directional shifts in the economy anyway?

Stock Prices and Economic Growth

It is well known that stock prices are an imperfect leading indicator of recessions and recoveries. As the economist Paul Samuelson famously quipped, "The stock market has predicted nine out of the last five recessions." But in reality, the relationship between economic cycles and stock prices is less erratic than such a comment might imply. Historically, cyclical upswings and downswings in stock prices have almost a one-to-one correspondence with upturns and downturns in economic growth.

ECRI's U.S. Long Leading Index (USLLI) is designed to anticipate cyclical turns in the economy, but the USLLI does not contain stock prices. Because the USLLI has a longer average lead over the economy than stock prices do, peaks and troughs in USLLI growth typically anticipate peaks and troughs in stock prices.

Meanwhile, growth in ECRI's Weekly Leading Index (WLI), designed to anticipate turning points in economic growth, has somewhat shorter leads than the USLLI, and may be used to confirm earlier signals of cyclical turns from USLLI growth.

Because stock prices are included in the WLI, the average lead time of WLI growth over turning points in economic growth is comparable to that of stock prices, though the WLI's leads are more stable.

Cyclical turns in WLI growth have shorter leads than USLLI growth, but longer leads than stock prices, against growth rate cycles. Thus, in terms of the typical sequence of events, USLLI growth turns first, WLI growth confirms those turns, stock prices follow the turns in WLI growth, and finally, cyclical turns in economic growth follow.
ECRI doesn't try to predict stock prices per se, but we can assess stock market risk. This risk is not a constant and really depends on where you are in the business cycle - an issue addressed by the USLLI and WLI.

For example, right now, things are not as risky as, say, in late 2000, but we've moved into a riskier phase of the business cycle than we were in just a few months ago. Depending on your risk profile, you may want to wait for USLLI and WLI growth to turn back up, because that will telegraph the low-risk, high-return phase of the business cycle.

Stock Price Corrections and Economic Cycles

While there is a fairly reliable sequence of cyclical turns in USLLI growth, WLI growth, stock prices and economic growth, there can be exceptions. A key question is whether sharp plunges in stock prices contain useful information about cyclical downturns in economic cycles or represent just noise. To answer this, ECRI examined the daily S&P 500 Index since 1950 and calculated the percent drop in each correction. Then, we collected the declines that measured at least 5%, approximating the size of the drop early this year. Remarkably, we found that three-quarters of the 84 such corrections (before 2007) in stock prices occurred during periods following USLLI and WLI growth downturns.

This relationship held in early 2007, as the USLLI and WLI had turned up, suggesting that the 6% February drop in stock prices was not a harbinger of weaker growth ahead.

Fast forward eight months and we all know that GDP rose 3.8% in the second and 3.9% in the third quarter, while stock prices recovered their February losses and are up almost 8% this year.

The Price of Crying Wolf

Basically, stock market corrections tend to be larger and nastier in certain phases of the business cycle, like when our leading indexes point to slowing growth. That slowing phase of the cycle has reemerged as a result of fresh downturns in the ECRI leading indexes beginning this summer. Some of the blame for this downturn goes to poor recession forecasting.

For over a year dire recession predictions have garnered headlines, despite objective data to the contrary. The fact is that median real home prices, which have been at the epicenter of growth concerns, stopped falling and rose from September 2006 through March of 2007, while GDP rebounded to above trend in the second quarter.

These realities blindsided Wall Street, forcing major houses to slash their 2007 rate cut forecasts last June from a range of 75 to 100 basis points to zero.

For adjustable rate mortgages due to be reset in the coming months, the likelihood of rates staying high was bad news that reduced their worth, especially in the subprime category. Thus, the abrupt invalidation of pessimistic projections helped precipitate the credit crisis. This in turn has had a material impact on economic fundamentals, contributing to renewed weakness in both the home price outlook and the broader economy.

Knowing the Nuances

For the past half a year, GDP measures show the economy growing solidly above trend. In the third quarter, the same report shows inflation falling to a 44-year low. That was a textbook Goldilocks economy.

Looking ahead, we're facing a broad based slowdown in economic growth, but have plenty of room to slow without slipping into recession. Most importantly, the objective ECRI leading indexes that correctly forecast past recessions - in real-time and without false alarms - remain above past recessionary readings.

Also, it is significant that the Fed has cut 75 basis points in six weeks. While the credit crisis is certainly a major concern, most observers underestimate the extent of receding underlying inflationary pressures. This means the Fed has more leeway to cut rates to alleviate the home price downturn and broader economic slowdown.

These are the nuances of the current U.S. growth rate cycle slowdown. One thing is for sure. The path of the USLLI and WLI will change, and we'll change our tune accordingly, because ECRI's outlook is not based on gut feel, but rather an objective reading of the fundamental drivers of the business cycle. This approach has kept us from being blindsided by recessions for many, many years.

-By Lakshman Achuthan; lakshman@businesscycle.com

Lakshman Achuthan is the managing director of the Economic Cycle Research Institute, (ECRI), an independent organization focused on business cycle research and forecasting in the tradition established by Geoffrey H. Moore. Lakshman is the managing editor of ECRI's publications, a member of Time magazine's board of economists, the Levy Institute's Board of Governors and the New York City Economic Advisory Panel. He is co-author of "Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy" published by Doubleday. Opinions expressed are those of the author not of Dow Jones Newswires