MONEY AND WORK

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March 10, 2009

THE MARKET AS PREDICTOR

Prudent Speculator - We looked at the latest sentiment figures from the American Association of Individual Investors. With data compiled as of March 4, those AAII members who responded to the bullish/neutral/bearish question were overwhelmingly negative. In fact, only 18.9% said they were bullish while 70.3% said they were bearish. That difference of 51.4% has been higher on only one other occasion in the 22-year history of this weekly gauge. When was that worse reading recorded? October 19, 1990. When did the market bottom that year? That same week.

Wikipedia - In the U.S. a significant stock market drop has often preceded the beginning of a recession. However about half of the declines of 10% or more since 1946 have not been followed by recessions. In about 50% of the cases a significant stock market decline came only after the recessions had already begun.

Brad Comincioli, Illinois Wesleyan - Another reason why skeptics do not trust the stock market as an indicator of the economy is because of investors' expectations. Critics reason that expectations about future economic activity are subject to human error, which in many cases causes stock prices to deviate from the "real" economy. Since investors do not always anticipate correctly, stock prices will sometimes increase before the economy enters into recession and decrease before the economy expands. As a result, the stock market will often mislead the direction of the economy. Even when stock prices do precede economic activity, a question that arises is how much lead or lag time should the market be allowed. For example, do decreases in stock prices today signal a recession in six months, one year, two years, or will a recession even occur?

An examination of historical data yields mixed results with respect to the stock market's predictive ability. Douglas Pearce found support for stock prices leading the direction of the economy. His study discovered that from 1956-1983, stock prices generally started to decline two to four quarters before recessions began. Pearce also found that stock prices began to rise in all cases before the beginning of an economic expansion, usually about midway through the contraction. Other studies have found evidence that does not support the stock market as a leading economic indicator. A study by Peek and Rosenberg, for example, indicates that between 1955 and 1986, out of eleven cases in which the Standard and Poor's Composite Index of 500 stocks (S&P 500) declined by more than 7 percent (the smallest pre-recession decline in the S&P 500), only six were followed by recessions. Furthermore, a study conducted by Robert J. Barro found that stock prices predicted three recessions for the years 1963, 1967, and 1978, that did not occur. . .

The 1987 stock market crash is one example in which stock prices falsely predicted the direction of the economy. Instead of entering into a recession which many were expecting, the economy continued to grow until the early 1990's

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