Does the Stock Market Anticipate the U.S. Economy?

Mish recently asked and answered a very good question: "Is the stock market a leading indicator?" Remarkably, he found that the stock market is, at best, a coincident indicator, which means that tells you in real time if the economy is distressed.

That's remarkable in that to arrive at that conclusion, which we believe is correct, he applied his technical analysis skills, using candlestick charts showing how stock prices have changed over time to try to divine how effectively those changes anticipated recessions in the U.S. As you can see in the chart Mish created, the picture provided by that kind of analysis produces more questions than answers.

The problem with using technical analysis is that it doesn't tie into the basic fundamentals that drive stock prices, namely how the growth rate of their underlying dividends per share is changing. If we want to really be able to answer the question of the whether the stock market leads, coincides or provides a lagging indication of the economic situation in the U.S., we need to find a way to incorporate this driver into our analysis.

That makes sense because we should expect companies to act to change their dividends depending upon the economic situation they foresee. If they anticipate a worsening business situation, they will cut their dividends. Likewise, if they anticipate strong growth ahead, they'll act to raise their dividends. In both cases, stock prices will change, falling in the case of cut dividends and rising in the case or growing dividends, as investors react to the changing business situation.

But then, dividends are not the only driver of stock prices. As Mish asks in his chart above in looking at the market crash of October-November 1987, "What's This, Chopped Liver? Or a Blown Call?" We would, after all, reasonably expect stock prices to plunge if investors suddenly anticipated major dividend cuts. So is there a tool we can use to isolate the signal the stock market is sending that can also tell us if the market is reacting to a situation in advance of it happening, is reacting in step with it, or is catching up after the fact?

The answer to all these questions is yes. The price-dividend growth rate ratio we've developed can indeed answer these questions

Our chart showing how the price-dividend growth ratio from January 1952 through September 2009 has changed over this time shows how. What we find is that the stock market provides a signal in the form of a spike that coincides to each and every recession declared by the National Bureau of Economic Research during this period of time, which corresponds to the modern age of the U.S. stock market. This spike is the result of the rate of dividend growth falling to a level of zero or changing from positive to negative in value.

More than that, we see that these spikes in value coincide with the periods of recession. This observation indicates that the stock market is most often a coincident-to-lagging indicator of the economic situation in the U.S.

But wait - there are more spikes in the price-dividend growth ratio than there are recessions! Is this a problem?

In short, no. What the price-dividend growth ratio is communicating is the level of distress seen by the companies of the U.S. stock market. What these "rogue" spikes correspond to may be thought of as microrecessions, or rather, periods in which economic growth slowed to a crawl or that reversed, but which either did not last long enough or did not affect enough of the U.S. economy for the NBER to declare a recession.

Looking at the crash of October-November 1987, we find that while stock prices fell off a cliff, there is no corresponding spike in the price-dividend growth ratio, so we can rule out the possibility of a recession or a microrecession being behind the drop in stock prices at that time.

All in all, our methods incorporating fundamental analysis represent a much more effective way to analyze the economy through the prism of the stock market than typical technical analysis alone.