As an MBA student at the University of Chicago’s Booth School of Business in the 1970s, I frequently heard finance professor James H. Lorie extoll the wisdom of his U of C colleague and idol, the legendary monetarist Milton Friedman. On one occasion, Lorie, a raconteur who talked in short, staccato bursts, recalled a session where a panel of professors were grilling a PhD student on a draft of his thesis. The doctoral candidate was presenting a model for forecasting U.S. economic growth that depended heavily on how stock prices performed in the prior months. “Then, this little man with no hair poses a pointed question,” recalled Lorie. “Milton Friedman asked, ‘How are this model’s predictions for next year’s GDP number better than taking the last five years of growth, and dividing by five?'”
In effect, Friedman was declaring that the fickle equity markets are worthless, or nearly so, as a predictor of booms and busts. History confirms that stocks make the wrong call on future recessions almost as often as they prove a bellwether. But in this coronavirus-driven selloff that’s already infecting the economy’s fundamentals with brutal contagion to come, the stock market is getting it right.
The 20%-plus fall in the S&P from its mid-February peak through March 11, marking the first bear market since the depths of the Great Recession 12 long years ago, is casting stocks as a prognosticator par excellence, a farsighted barometer for where the economy is heading. Chris Brightman, chief investment officer of Research Affiliates, a firm that oversees strategies for over $150 billion in mutual funds and ETFs, notes that we’re in a rare period where equities are pointing the same way as all the other capital market indicators, in this case universally downwards, as shown by collapsing oil prices, all-time low 10-year treasury yields, and ballooning credit spreads.
So the stock market is looking like a mighty reliable gauge for a change. And it’s auguring that a recession is getting a lot more likely. “The markets are sending us strong and consistent signals that slowing growth over the coming months is a near certainty, and that the probability of recession has spiked up,” Brightman told Fortune. All of the economists whom I interviewed for this story shared his prognosis. “The probability that the stock market is forecasting a recession is higher than usual,” says Jared Franz, an economist at Capital Group, the giant fund manager. “We’re getting closer to the recessionary tipping point.” Economists Mark Zandi at Moody’s Analytics and Gus Faucher of PNC now reckon that the odds of recession have risen sharply in the last three weeks in concert with the big selloff, to around 50-50. As recently as January, Faucher put the chances we’d encounter the “R” word this year at just 20%.
That top economists view the market’s meltdown as a harbinger for a melting economy is unusual indeed. Over the past 80 years, stock prices have proven a poor guide for things to come. Since 1937, the U.S. has suffered thirteen recessions, the first starting in 1937, and the last commencing in late 2007. A recession is defined as a GDP decline for two consecutive quarters, as measured by the National Bureau of Economic Research. On average, those thirteen recessions lasted 10 months, and shaved an average 3.6 points from national income.
In six cases, the S&P 500 index increased over the six months prior to the onset of the recession. In only one instance did the S&P drop more than 10% in the half-year before the downturn, falling 11.1% ahead of the dotcom retreat starting in March of 2001. The other six declines averaged just 3.5%. In the six months before the dawn of the Great Recession that would sink GDP by a disastrous 4.3% and stocks by almost half, the S&P 500 shed a paltry 3.2%.
Given that big cap stocks have cratered by 20%, it’s logical to study how often a decline of that magnitude has presaged a recession. In the past 83 years, the S&P has fallen 20% or more in a six month period on 11 occasions. In five cases, those big drops didn’t foreshadow a recession, the declines of 1940, 1941, 1946, 1962, and 1987. By the way, the biggest slide between the end of the Great Recession in June of 2009 and today’s rout was a fall of around 13.5% in late 2018 triggered by the Fed’s rate hikes.
While stocks do a poor job anticipating recessions, they tend to fall sharply during the slump. The S&P slid 40% in the 1937-38 contraction, 37% in the Great Recession, 23% in the OPEC oil tremor from late 1973 to early 1975, and 13.4% in the dotcom pounding. (Two of those 20%-plus drops actually occurred during, not before the dotcom recession.) But in six of the thirteen recessions, shares rose. For example, the S&P increased by 20% during the downturn that lasted from July of 1953 to May of 1954. That demonstrates why it’s so hard to predict how equities will fare in the course of recession, if indeed we get one. Judging from the past, if a big selloff strikes prior to the onset of an economic downturn, and the hit is relatively mild, markets anticipate the companies will perform well in the future, and stocks can advance even while GDP is shrinking.
I spoke to Milton Friedman many times before his death in 2006, during the years he’d moved on to the Hoover Institution. I’d leave messages for the great man with his assistant, and later get a return call from an operator inquiring, “Will you accept the charges from Milton?” Friedman quipped one time, “I was most amused by the operator calling me Milton.” I never asked him about how reliably the stock market forecasts recessions. I didn’t have to. I already knew his stance from Professor Lorie’s anecdote.
And as usual, he was right.
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