Bad Backward-Looking Logic

Economic slowdown?!?! Head for the hills! One of the media's favorite reasons to be dour this year has been the incremental slowing of US GDP numbers. The inference being, of course, that GDP growth predicts future stock market movements.

Let's consider the issue using the first question in The Only Three Questions That Count (www.onlythreequestions.com): What do you believe that is actually wrong? Investing myths run rampant in financial markets—debunking a commonly accepted fallacy is step one in making successful investment decisions. Most investors subscribe to the notion that metrics like GDP impact future stock market returns. As it turns out, the stock market does a far better job of predicting economic growth, not the other way around.

Why? The stock market is a discounter of all widely known information. That means it takes into account future expectations of economic growth in stock prices. When most investors buy an asset like a property, stock, or even a company, they analyze its future return prospects. Stocks always look forward, not backward. After all, the prospects of the most successful candle stick business in the world looked a little dimmer after the invention of the light bulb.

So it's easy to see how GDP is not useful for predicting stock returns. GDP can only tell us about history…and what use is that to someone seeking future returns? Released quarterly, GDP measures consumption, investment, government expenditure and net exports from the previous 12 months. What's more, GDP is derived from data three months prior to the release. So a final revised number released in January of 2006 measures economic activity from September 2004 through September 2005. And like so many other government statistics, GDP is typically revised several times after its release. We only really know GDP five to six months after the events already took place! (Unfortunately, we don't have room in this column to detail all the dubious statistical methods used to calculate GDP. But rest assured, there's a lot to critique.)

Not convinced? Let history and empirical evidence be your guide. The charts below plot the most recent instances where the S&P 500 moved before the economy did (as defined by the National Bureau of Economic Research). The shaded areas are periods of economic recession while white areas represent economic expansion. Note the relationship between the stock market and the shaded areas. Generally, the stock market drops before recession begins. Similarly, stocks rally well before the end of an economic malaise. Most people fail to catch on to this phenomenon. During recessionary periods, media doom and gloom causes many investors to abandon all hope, much less see the bear market as a great investment opportunity.

Let's apply our history lesson to the present day. A consensus among the media and economists tout an economic slowdown that will depress corporate earnings and consumption and ergo, the stock market. Yet, in the face of such dour predictions, stocks keep powering ahead and are making new highs for the year. The only truly efficient future economic indicator (the stock market) is telling us something backward statistics (pun intended) can't: economic growth heading into 2007 will be strong.

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Sources: NBER, Datastream

Note: The content contained in this article represents only the author's personal opinions and viewpoints.