Which Improves First - The Stock Market or the Economy?

Historical data suggests the equity markets improve before the economy begins to show some economic strength. As a result, can investors afford to sit on the sidelines before they see signs of an expanding economy?

In his book, Stocks for the Long Run, Jeremy Siegel, a professor at The Wharton School, notes that:

...of the 42 recessions from 1802 to the present (2002), 39 of them, or 93 percent, have been preceded (or accompanied) by declines of 8 percent or more in the total stock returns index. Historically, a bottom in the market has led a trough in the business cycle by about five months.

Investors will have little luck predicting market upturns and downturns because turning points are usually identified months [after] they’ve occurred, not beforehand. In the meantime, they’ll miss out on significant gains. From the bottom of the market to the end of the recession, the stock market has risen an average of about 24 percent (emphasis added).

(click on chart for larger image)

Source: BetterInvesting Magazine

Certainly there have been false signals; however, if an investor's risk tolerance and asset allocation profile calls for equity exposure, staying in the market is almost a prerequisite to achieving market beating returns. As I noted in an earlier article, Focus On The Long Run, timing the market is very difficult. If an investor is out of the market on those days when the market gaps higher, long run returns will be impacted negatively.

Source:

• Don't Wait for the Clouds to Break ($) BetterInvesting Magazine, BetterInvesting Editors, September 2008

Comments

[phdinsuntan...:]

try the currency

2008 Sep 01 08:09 AM

[inthemoney:]

I would be intrested to see if there is a link between the length of a downturn and how money months before the end of it the market turns. I beleive it is too early to predict the end of the bear market yet this time. Give it a year or so.

2008 Sep 01 08:14 AM

[unimpressed...:]

The market will continue to seesaw as long as the price of oil remains at its present highs. The economy will be stagnant or depressed under the same conditions.

If the electorate wakes up to the fact that the Democrats in Congress, or anywhere else, are incompetent and totally clueless and sends them home in November, things will change, quickly. Under a Republican majority with a Republican President, Drill Here, Drill Now will be enacted and oil prices will plunge. The market and the economy, in tandem, will take off.

However, if the voters cling to outmoded ideology, ignore reality, and retain the clowns, the market will plunge to record lows and the economy will slip into depression, not recession.

2008 Sep 01 08:41 AM

[investor88:]

Agree with inthemoney comments that we need to give a year or so for the bear market to be over. It is a misconception that we must always stay invested for fear of missing the upturns. There will be times when it can hurt to stay invested just as being out can hurt returns. A year ago some wise people said return of capital is more important than return on capital, it turned out to be sound advice on hindsight.

2008 Sep 01 09:33 AM

[sabbadoo32:]

We can "drill here, drill now". There's plenty of leased land available to oil companies to do that. However, there are constraints on man and equipment to do that. Doing some Googling will lead you to oil drilling industry information that tells you boats, derricks exploratory equipment, etc are currently leased through 2010 on existing projects. It's not a democrat trick, it's the fact that the industry is always looking for new oil somewhere.

Personally I believe market bottom will largely coincide with a significant decrease in unsold housing inventories and a stabilization in commercial real estate. Household savings need to rebound, household credit balances need to decrease. Home values need to begin to rise again. When the middle class feels comfortable about spending money again, we'll get our recovery--which should coincide with a stock market rally. These are the things that will lead to a sustained recovery.

2008 Sep 01 10:08 AM

[OldLimey:]

CLH: if the market foresees the economy, what was it up to last October - three months after the credit crisis broke publicly and 7 months after Doug Kass first flagged the potential implications of the sub-prime problem for the real economy? The market is a heavily manipulated forum populated largely by lemmings, most of whom think what they're told to think. It certainly cannot be ignored, but it doesn't deserve adulation.

2008 Sep 01 01:41 PM

[whidbey:]

I am encouraged to learn this sequence again; it is true historically, but you did not mention the "false" starts the prescience investors usually make. Sort of testing periodically with small amounts of money, then one day it works and the tide as turned. But you paid the ticket to ride in each false start. This gets old you know, or should I say, I know.

2008 Sep 01 08:29 PM

[Steven Hansen:]

the market always goes up before the economy thanks to the permabulls who continue to push up. the issues in this downturn have not been resolved yet and as each shoe falls, the permabulls are beaten back. i would like to see a correlations on reasons for the stock market recessions to the times to recovery.

2008 Sep 01 08:42 PM

[Chris B:]

You just have to dollar-cost average into and out of the market over several months when you suspect a change is coming. Don't expect to buy or sell within 10% or the bottom or top. Be a skeptic in all things. Arrogance will destroy your portfolio.

OldLimey has a point, the market is sort of a media echo chamber. Why else were investors more worried about missing out on gains a year ago when a year later they would be more worried about preserving capital. Why should past performance affect our investment methods? Why do people focus mainly on the information that everyone else is focusing on?

Understanding psychology and reversion to the mean might be all it takes to make money in this market.

2008 Sep 02 11:07 AM