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Can Stock Market Bears Smell Recessions Better?

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Wall Street and the economy

In developed economies like the US, the stock market and the real economy are closely linked, or at least this used to be the case. With return on capital far exceeding wage growth and higher expectations from companies like Google (GOOG) and Amazon (AMZN), there is an increasing disconnect between the stock market performance and other indicators. However, it’s the stock market (SPY) performance that drives investor expectations about the real economy. The reason is simple. It’s much easier to be panicked or jubilant due to the stock market than due to obscure indicators like PMI. A useful analogy is to think of the stock market as hard-to-ignore constant noise. It’s hard not to get affected by it. If it’s a sweet melody, it feels great. If it is not, it’s easy to get annoyed.

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Bulls and bears have a stronger sense of smell

We ran a quick analysis of the S&P 500’s monthly performance three months, six months, and one year immediately before each of the last seven recessions started.

As you can see from the above chart, the S&P 500 (IVV) tanked three months and six months prior to recessions four out of seven times. It was down three months prior to but up six months prior to the recession that started in January 1980. It was down six months prior to but up three months prior to the two most recent recessions, the 2001 recession after the dot-com (XLK) burst and the great recession of 2007 fueled by the subprime crisis (XLF).

Paul Samuelsson once jokingly said that the stock market has predicted nine of the past five recessions. While there is some evidence for the stock market being a leading indicator, investors should note that it hasn’t always been perfect in the case of most recent recessions.

As you can see, the three-month performance of the S&P 500 acted as a reasonably good indicator of the recession until the turn of the century.

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