Bear mar­kets don’t pre­dict re­ces­sions

The Pak Banker - - OPINION - Stephen Mihm

AS the world's eq­ui­ties mar­kets are buf­feted by bouts of in­ten­sevolatil­ity, an­a­lysts have started ut­ter­ing a chill­ing phrase: bear mar­ket. China's mar­kets have en­tered this ter­ri­tory, and the U.S.might not be too far be­hind.

That pos­si­bil­ity in­vari­ably leads to spec­u­la­tion that the de­clines are har­bin­gers of worse to come, in other words, a re­ces­sion. This ques­tion has at­tracted rel­a­tively lit­tle at­ten­tion from econ­o­mists and schol­ars, per­haps be­cause of a mem­o­rable take­down by Paul Sa­muel­son. In a Newsweek col­umn in 1966, the famed econ­o­mist fa­mously quipped that bear mar­kets had a re­mark­able record as a lead­ing in­di­ca­tor, hav­ing pre­dicted "nine out of the past five re­ces­sions!"

It's a great joke. And cer­tainly, when it comes to the some­what ex­cep­tional pe­riod of eco­nomic his­tory be­tween the Great De­pres­sion and the most re­cent re­ces­sion, other lead­ing in­di­ca­tors have a bet­ter track record of pre­dict­ing the fu­ture. The yield curve, for ex­am­ple, has pre­dicted all U.S. re­ces­sions ex­cept one since 1950.

But this does not mean that stock mar­ket tur­moil is ir­rel­e­vant to the larger econ­omy. For ex­am­ple, the econ­o­mists Ar­turo Estrella and Fred­eric Mishkin pub­lished an ar­ti­cle in 1998 that ex­am­ined the pre­dic­tive power of a range of lead­ing in­di­ca­tors in the post­war era. Af­ter crunch­ing the his­tor­i­cal data, they con­cluded that "the yield curve spread and stock price in­dexes emerge as the most use­ful sim­ple fi­nan­cial in­di­ca­tors," and that when com- bined, of­fered a lead­ing in­di­ca­tor more ac­cu­rate than ei­ther one alone.

Other re­searchers have cor­rob­o­rated th­ese find­ings, and es­tab­lished that stock mar­ket per­for­mance has some pre­dic­tive power, though it also has gen­er­ated its fair of false alarms. A his­tor­i­cal study by Har­vard's James Stock and Prince­ton's Mark Wat­son re­viewed the re­la­tion­ship be­tween eq­ui­ties prices and eco­nomic out­put in seven de­vel­oped na­tions be­tween 1959 and 1999. They con­cluded that "some as­set prices have sub­stan­tial and sta­tis­ti­cally sig­nif­i­cant marginal pre­dic­tive con­tent for out­put growth at some times in some coun­tries."

Now that's what you call hedg­ing. In any case, their find­ings didn't ex­actly con­sti­tute a ring­ing en­dorse­ment of stock prices as a crys­tal ball for see­ing re­ces­sions on the hori­zon. But there's an­other way that the be­hav­ior of the stock mar­ket may be a har­bin­ger of things to come. A 2010 pa­per pub­lished by three Nor­we­gian econ­o­mists -- Randi Næs, Jo­hannes A. Sk­jel­torp and Bernt Arne Øde­gaard -- ze­roed in on "mar­ket liq­uid­ity."

In a liq­uid mar­ket, stocks can be bought and sold with­out sig­nif­i­cant al­ter­ations of the ex­ist­ing price. For ex­am­ple, some­one at­tempt­ing to sell shares will find buy­ers above and below the ask­ing price, and the trans­ac­tion it­self doesn't dra­mat­i­cally im­pact the ex­ist­ing price. An illiq­uid mar­ket, how­ever, ex­hibits the ex­act op­po­site set of ten­den­cies: trades tend to dis­tort the price be­cause the mar­ket doesn't have the same depth and breadth on both sides of the trade. Put dif­fer­ently, a liq­uid mar­ket is one with a healthy ca­coph­ony of asks and bids. An illiq­uid mar­ket is the fi­nan­cial equiv­a­lent of crick­ets chirp­ing.

There are dif­fer­ent ways of mea­sur­ing liq­uid­ity (or illiq­uid­ity). The most ob­vi­ous is to cal­cu­late the change in price per unit of trade vol­ume. Th­ese es­ti­mates come in a va­ri­ety of fla­vors. The best known, per­haps, is the Illiq­uid­ity Ra­tio, or ILR, de­vised by Yakov Ami­hud, a pro­fes­sor at NYU's Stern School of Busi­ness. And this is what the Nor­we­gian econ­o­mists used to ex­am­ine the his­tor­i­cal data, though they also re­lied on sev­eral other com­pa­ra­ble mea­sures of stress in the mar­kets, or illiq­uid­ity. Ex­am­in­ing data from 1947 to 2008, the re­searchers found that "mar­ket liq­uid­ity seems to be a par­tic­u­larly strong and ro­bust pre­dic­tor of real GDP growth, un­em­ploy­ment and in­vest­ment growth." Con­versely, ris­ing lev­els of illiq­uid­ity con­sis­tently sig­naled that a re­ces­sion was on the hori­zon. There were a few false alarms, but in gen­eral the ev­i­dence is rather strik­ing.

Why would an in­suf­fi­ciency of buy­ers and sellers be a sign of any­thing? The au­thors spec­u­lated that ris­ing illiq­uid­ity may be a symp­tom of a "flight to qual­ity" symp­to­matic of grow­ing pes­simism about the di­rec­tion of the econ­omy. Given that this trans­lates to a move from the stocks of small, more risky com­pa­nies to big, blue chip ones, the au­thors fo­cused on th­ese smaller firms. They found the illiq­uid­ity of th­ese stocks was "most in­for­ma­tive about fu­ture eco­nomic con­di­tions." The pre­dic­tive power of liq­uid­ity was even more pro­nounced. All of which raises the ques­tion of the hour: What are the mar­kets do­ing now? Try to fig­ure it out for your­self.

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