Is the Stock Market predicting Another Recession?

Last weekend, I hosted a poker game with some friends. During one hand, I made a series of bets, which caused my opponent to think hard.

One of the other players coached him: “He’s trying to tell you a story with the way he’s betting. The question is, do you believe what he’s telling you?” My opponent believed me and folded. Good thing for him, too, as I had a full house!

Like a good poker player, the stock market is also telling us a story. The difference, however, is that the market is usually believable!

But here’s what many investors don’t understand: the market tells us the story of what will happen, not what has happened.

For example, my father is constantly asking me why the market was up or down on a certain day. Perhaps your family and friends do, too. But they’re missing the point.

Sure, the market sometimes responds to data or news. But it doesn’t usually react to the news. The news often reacts to the market.

Why? I’ll show you…

What Comes First… Market Behavior or News?

The point about the “market behavior in relation to news” equation resonated with me when I listened to a fascinating speech by Elliott Wave Theory expert, Bob Prechter.

In this instance, though, Prechter didn’t discuss Elliott Wave. Instead, he showed the correlation between all kinds of data and events that took place after important moves in the market.

Take wars, for example. They tend to break out when the market is bad – something that makes sense when you think about it. When the market is down, people feel poorer and are more irritable. It’s easier to get them to support a war. Plus, elected officials want to distract the public from their economic woes.

There is a precedent for this theory…

I attended Prechter’s talk in the spring of 2001, as the market was in the middle of the dotcom collapse. In March 2003, the United States invaded Iraq. At that point, the market was down 45% from the highs of March 2000. I can’t help but wonder if that war would have ever been fought if we were still in a bull market.

Bulls, Bears and Birth Rates

Bear markets also spark decreases in birth rates.

Again, it makes sense that when people are less comfortable financially, they put off new financial burdens like a child. Not to mention, financial stress makes people less amorous.

The opposite is true of bull markets. During and shortly after bull markets, the birth rate usually rises.

I was reminded of Prechter’s talk last week when news came out that the U.S. birth rate was the lowest in history.

In 2007, for example – the top of a four-year bull market – there were 14.3 babies per 1,000 of the population. That year, more babies were born in the United States than in any other year in America’s history.

But in 2009, the figure dropped to 13.5 babies born per 1,000 people. The marriage rate also decreased from 7.3 per 1,000 in 2007 to 6.8 in 2009.

Look Forward, Not Back

The fact that the stock market is a forward-looking mechanism makes me less concerned about every piece of economic news that the pundits use to justify their “next Great Depression” or “Big Bubble” theories.

Take 2008, for example. As the market plunged on the back of the financial crisis and several huge corporate meltdowns, it indicated that a nasty recession was on the way. In addition, it perhaps predicted an election victory for Obama, as he was perceived as anti-business.

But a funny thing happened. In 2009, the market rallied hard. The upward move in stocks suggested that the economy was no longer falling off a cliff. Yes, things were still tough, but the panic that many felt in late 2008 was no longer justified.

So what story is the market trying to tell us today – and how do we interpret the data?

Are You Asking the Right Question?

Currently trading around 1,050, the S&P 500 is down 16.1% from its late April high. So does it signal that a double-dip recession is headed our way?

If the index slips much further, I believe it does. However, if it can hold its current level and work its way higher, better days may be ahead.

The bottom line here is that the market predicts the country’s future economic direction, rather than news moving the market. So the next time stocks head in a certain direction, don’t ask, “What happened to make the market move?” Instead ask, “What is the market telling me is going to happen?”

Hoping your longs go up and your shorts go down.

Source: Marc Lichtenfeld