The behavior of the stock market has always been considered a leading economic indicator. In fact, the performance of the S&P 500 index is used by the Conference Board in calculating the official US Leading Indicators. Nevertheless, could it be that share prices are now lagging indicators? Let's look at the data.
The chart below (click to enlarge) plots the annual percent change in S&P 500 (blue line) vs. the performance of the "real" economy: annual changes in retail and restaurant sales (red), new orders for manufactured goods (pink), housing starts (green) and private employment (olive).
Notice how the broad economy started weakening in 2006 but stocks kept moving higher, even accelerating their ascent, until recently. Clearly, stocks were lagging the real economy.
In my opinion, the following are the main reasons for this unusual behavior:
- Stock valuations remained high because financial engineering spread out credit risk via derivatives (CDOs, CLOs, CDSs, SIVs, etc.). This theoretically lowered the overall business cycle risk and ultimately resulted in low equity risk premia (i.e. higher P/Es). As we found out, this was a fundamental mistake: Cutting the risk salami into thinner slices didn't make the salami itself any smaller and lots of it eventually found its way into places where it didn't belong (e.g. money market and pension funds). Food poisoning ensued and the market has now gone into purgative mode.
- After two decades of the Greenspan put, people believed that the Fed and other central banks could always bail out investors by cutting rates to the bone. However, under credit crunch and zero saving conditions it is near impossible to adequately stimulate the economy - and business profits - by just cutting interest rates. The result has been a panicky government rushing to provide fiscal stimulus.
- Strength in BRIC economies was supposed to counterbalance a possible Western slowdown and keep raising profits for global corporations, i.e. decoupling. I maintain that the BRIC surge is largely derivative and highly fragile, a product of supplying and vendor-financing over-indebted consumers in the US and the EU. This remains to be proven, but I note with interest that Chinese officials emphasize that their growth is heavily dependent on exports and that Arab oil producers refuse to raise production, even when publicly scolded by President Bush, fearing a collapse in prices from lower demand (assuming they can raise production, of course).
- Almost the entire world has accepted the capitalist laissez-faire model, theoretically allowing the invisible hand to guide profits ever higher, without meddlesome government interference. My personal view is that this is tantamount to unchecked reliance on religious dogma and that is will end badly, but, once again, it remains to be seen.
- All of the above are combined into the Great Moderation Theory (GMT), which holds that recessions will be infrequent and shallow, resulting in small peak-to-trough profit declines. In other words, the theory proclaims the effective abolishment of the business cycle.
Back to the stock market: from previous posts we know that corporations and investors "bought" into the GMT concept and kept replacing equity with debt in their balance sheets, removing unprecedented amounts of equity from the market via buy-backs and LBOs (see chart below). In other words, they have bet the farm on the economy not going into a serious recession (this explains the panicky rate cuts from the Fed).
All of the above, taken together, had up to now kept share prices higher than otherwise - i.e. stocks lagged the economy. Therefore, we may soon discover if the Great Moderation holds, or if it turns into the Great Unravelling.