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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Bull Market & Economy


Six days after the fall of Kabul, Wall Street's most famous stock index struck a gain of over 20 per cent gain from its post-terrorism low point, a rise big enough to meet the vernacular definition of a bull market.

And market lore says that where the bull charges, the economy is sure to follow. Studies such as one by a former Federal Reserve economist, Douglas Pearce, show that the stock market has always predicted American economic recovery by at least six months.

The Dow is not the only hint that revival is on the way for the world's biggest economy.

A man who methodically scours hundreds of hints, so-called leading indicators of the US economy, is the head of research at the Economic Cycle Research Institute, Mr Anirvan Banerji. He was one of the first to foresee America's current recession. Now he says:

"For a while the stock market was the only evidence pointing to a forthcoming recovery, but in November we have a couple of other important leading indicators showing signs that activity is stabilising and perhaps even improving a little..."

In the US financial media, a debate is unfolding in earnest exploration of whether the US is in the early stages of deflation - a fall in the general level of prices. In modern times, the word deflation has not had happy associations. The very word conjures Depression memories and a Japonesque twilight of endless stagnation.

The TV network CNBC, whose relentless cheer leading of the frenzy on Wall Street until a few months ago earned it the nickname of Bubblevision, lately offered viewers a brisk tutorial in deflation and how it works.

And the International Monetary Fund has just now conceded that the world economy is entering its first synchronous recession in a generation. The OECD has this week predicted that the developed world will suffer economic contraction of 0.3 per cent.
But all these indicators have very limited power of divining the future.

Industrial output is a story of what's just happened rather than what's about to happen; trends in prices lag the level of economic activity rather than lead it.

[T]ake a closer look at the happy leading indicators. Anirvan Banerji says that of the bullish indicators he cites, "they are very good indicators, but we do not yet have enough to decide anything - you simply can't conclude anything from a few weeks' data in any time series, no matter how good it is.

"It's not necessarily wrong to say that there will be an early recovery - it's just that it's highly premature to declare it with the data we have."
And whatever happened to the market's favourite leading indicator as recently as a few months ago - the National Association of Purchasing Managers survey of managers' buying intentions?

"It's showing the lowest level in nearly two decades, but the market only follows it closely when it suits it," Mr Banerji sneers.

And what of that great indicator, the stock market itself? There are two important points about the market's latest burst of bullishness. One is its source.

The first faint suggestions of recovery have been amplified by some of America's biggest and most aggressive investors, its hedge funds.

Always straining for the latest gossip and faintest hints of the next big trend, the hedge fund managers read an issue of a newsletter from Medley Global Advisers last week.

"Senior level sources within the Fed have identified a change of mood throughout the central bank," said the report.

The Fed now believed that the "worst of the slowdown is behind us," it said.

The hedge funds, fearing that they were about to be surprised by a sea-change, quickly became big buyers.

This episode was important, says David Hale, "because Medley is so closely followed by the hedge funds, and because it was talking about a sudden change in official perceptions, it really it spooked the hedge funds and that spooked the market and the market over-interpreted it."

In public remarks since, two Fed officials have plainly said that they did not believe that the worst was past.

The second point about the market is that its bull run does qualify for the vernacular definition, but it does not stack up to a common sense definition. The strength of the stockmarket has been neither pervasisve nor persistent.

The Dow spent precisely one day in bull territory before promptly retreating. It also made an earlier run-up in April and May before a relapse.

The Nasdaq index of technology stocks has made a run-up of 20 per cent plus on four occasions since it began its long drop last year, only to slump anew every time.

Jim Grant, the publisher of Grant's Interest Rate Observer, says that "as a member of the American tribe I would like to be able to say that the market is an expression of American entrepreneurial derring-do, but there's a quarter century of financial conditioning that the Fed will intervene to stave off every problem...I think it's acting on that conditioning."

A bull market may indeed be a reliable predictor of the economy. It's just that, since the bust began, we haven't seen a true one yet.
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