Bill Jamieson: Market can be misleading regarding forecasts

Wall Street indexes predicted 'nine out of 'the last five recessions. Picture: PA
Wall Street indexes predicted 'nine out of 'the last five recessions. Picture: PA
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Barely a month ago shares were plunging on fears of economic dislocation and global recession.

The FTSE 100 plunged to 5,500 at one point – down 20 per cent in late January from the record peak in April last year as fears of a major downturn gripped markets.

A 20 per cent downturn is normally considered to be a bear market and harbinger of recessionary downturn. Newspaper headlines warned of a repeat of the 2008 global financial crash. But last week prices continued to recover and the FTSE 100 has now swept back up to 6,140, as of Friday’s close. What are investors to believe? The stock market has long been considered a barometer of business mood and pointer to what may lie ahead in the real economy. But the market has proved highly misleading when it comes to accurate predictions of real economy performance.

A paper just out from the Centre for Policy Studies by Daniel Mahoney and Tim Knox puts a major question mark by the stock market’s ability to correctly forecasting downturns and recessions. It drives home that sharp observation by the late US economist Paul Samuelson that “Wall Street indexes predicted nine out of the last five recessions. And its mistakes were beauties”.

The paper finds that in more recent times, the UK stock market appears to be even less accurate in predicting UK recessions. It points out that since the FTSE 100’s inception in 1984, there have been 11 bear markets, but only two recessions.

Moreover, the stock market remained unmoved during the recession in the early 1990s. That has led a number of UK analysts to suspect that the bear market recorded by the FTSE 100 in late January is “noise” and is not the pre-cursor to a recession. Across those periods when markets signalled a major downturn, global economic growth was stable, growing by 3.3 per cent 3.3 per cent in 2013, by 3.4 per cent in 2014 and 3.1 per cent in 2015.

So to where should investors turn in seeking to find out what lies in store for the economy and for company earnings? Joseph Carson, a US economist for the research firm Alliance Bernstein, relies on three economic factors: new manufacturing orders, new building permits and job creation numbers. In the UK, the three metrics that align with these measures are the manufacturing purchasing managers index surveys (PMIs) house building starts and the unemployment rate.

Mahoney and Knox suggest that these indicators – in conjunction with one another – are relatively effective at predicting recessions. Housing starts – considered a leading economic indicator – fell by 35 per cent in the two years leading up to the recession in the early 1990s and there was also a dramatic fall in housing starts prior to the financial crisis, plunging by nearly 60 per cent from the first quarter of 2007 to the third quarter of 2008.

There was also a modest fall in manufacturing PMI before the financial crisis, where PMI fell below 50 in May 2008 – indicating a contraction in activity of the sector. Unemployment trends appear to be a lag factor – only increasing significantly after the onset of a recession in the UK.

While there has been clear evidence of a slowdown overall in the UK, with the Budget this week expected to see a reduction in the growth forecast from 2.4 per cent to around 2.2 per cent, these indicators are all holding up relatively well, suggesting that a recession is unlikely in the foreseeable future.

UK manufacturing PMI is at a three-month high of 52.9 and improved domestic demand is supporting the expansion of output. Any figure above 50 indicates an expansion in manufacturing activity. And the employment picture remains very positive, with the UK unemployment rate down to 5.1 per cent compared with 5.7 per cent a year earlier.

Now problems we certainly have – in export performance, a modest rate of earnings growth and in manufacturing activity where there has been a slowdown. We cannot easily avoid downturns. Markets are particularly sensitive to government deficit and debt performance. Here Chancellor George Osborne is set to reveal a more modest improvement in the budget deficit from the forecasts made in the November Autumn Statement.

But barring unforeseen global shocks, the likelihood of a recession this year is small. Despite the falls in the stock market, the CPS paper concludes, “the value of the FTSE 100 is notoriously inaccurate in predicting an economic downturn. Other economic indicators… mean the chances of a recession in 2016 are perhaps lower than many expect.” Investors should take a wider view than short term market swoons.