The need for security and the desire to anticipate any economic lurch in time, makes us pay great attention to the so-called leading indicators. For this reason, economists carefully analyze the movements that occur in the stock markets.
Leading indicators, unlike conventional indicators, such as GDP or the public deficit, among many others, provide us with data on economic events that have already occurred. On the contrary, leading indicators try to anticipate movements in the economy. In this article we are going to see why the stock market is considered a leading indicator.
Thus, thanks to economic indicators, it is a question of forecasting consumption, possible sales or demand for a certain type of product. Some of these indicators are the Consumer Confidence Indicator, the PMI index on manufacturing, purchases and services, the real estate market, construction licenses or the transport sector indices.
However, above the aforementioned leading indicators, one stands out: the stock market.
The stock market and economic cycles
Some people consider the stock market an excellent leading indicator. In fact, the increase in stock markets usually brings very positive omens. Companies will increase their activity and the value of their shares and, therefore, their profits will also grow.
But, if the bags fall, good omens will not come. Companies will see their economic activity reduced while the value of their shares falls. All this means that the economy could move towards a crisis scenario or fall into stagnation.
However, it should be noted that these two premises are not always fulfilled. In fact, the fall in the value of company shares does not have to be the prelude to an economic crisis. Thus, the decline in the value of a company on the stock markets may be the result of a simple change in market trends or a price correction.
That the value of the shares of a company increases, will necessarily be associated with an imminent stage of economic boom. Proof of this are the numerous situations in which the value of company shares has increased in contexts of crisis and slowdown.
Let’s take the subprime crisis as a reference. In the years 2007 and 2008, while the US economy was stagnating, and even when the crisis worsened, the stock markets recorded significant gains.
It is clear that economic indicators such as GDP, inflation or the public deficit are prepared a posteriori and that they include events that have already happened. But any news or rumor can influence the price of companies, even before they get results.
It is worth noting that in 2020, the stock market proved to be a reliable leading indicator. In fact, given the imminence of negative news, during the first three months of 2020 the stock market crashed. By the time the pandemic was a harsh reality and GDP was sinking, the stock market had already put the gloomy news behind it.
Of course, it may seem contradictory to many that the stock market falls in times of economic optimism or that stock markets grow in times of recession.
Despite the numerous studies that have tried to establish a direct correlation between the direction of the stock markets and the economy, it is difficult to draw conclusions. We see, therefore, that the relationship between the economy and the stock market can become capricious.
So, immersed in a sea of doubts, we will ask ourselves: does the stock market really serve to anticipate the progress of the economy?
The capricious relationship between the economy and the stock market
Although there may be a certain degree of correlation between what happened in the stock markets and the variation in GDP, there are a number of factors that explain why the stock market is not always a 100% reliable economic indicator.
In the first place, it must be taken into account that the future weighs more on the stock market than the economic events of the present. Thus, investors focus on the future returns that the different companies will offer them and do not attach as much importance to the increase or decrease in economic activity reflected through a conventional economic indicator such as GDP.
Secondly, the valuation of the companies in the different sectors does not show what their contribution to GDP has been or will be. A clear example is the valuation of technology and communications companies. These account for 35% of the market value of the 1,000 largest companies in the United States, but only account for 8% of US GDP.
It should also be noted that, in economic policy, the possibility of influencing the stock markets is much faster and more agile than if it is intended to influence the GDP. Thus, monetary policy allows rapid intervention in the markets through the purchase of public debt securities in the markets themselves.
In fact, if the central banks decide to inject more liquidity into the economy, all this has an immediate impact on the stock market. An increase in liquidity can generate an increase in the demand for shares in the short and medium term, breaking the market equilibrium.
On the contrary, if it is intended to act on GDP, fiscal policy turns out to be a much cruder instrument. Well, to introduce changes in fiscal matters, the approval of the parliament is necessary, which supposes a more dilated process in time.
Another limitation of the stock market as a leading indicator is its inability to predict what may happen to small businesses. And it is that the markets only take into account the large companies that are listed on the stock market.