Markets – Truly a Leading Indicator?

Apr 21, 2008: 10:17 AM CST

Barry Ritholtz at the Big Picture recently asked the question: “Are Markets a Leading or Lagging Indicator” which addressed the commonly held notion that markets lead economics (or financial conditions as they develop).

Barry states, “There are so many varied inputs into equity markets — sentiment, trend, liquidity, momentum, valuation — anyone of which can be dominant at any given moment.  Merely assuming markets are giving you a 6 month heads up into the future, based on recent action, is often unwarranted.”

He further addresses data from the housing market (and ‘credit crunch’) market declines and takes us back to 2000 when the market rallied into a recession and then bottomed near the start of the economic recovery.

Ritholtz concludes that markets can both lead and lag, which challenges conventional wisdom. “But getting the correct interpretation involves careful review of the charts, sentiment reads, liquidity, momentum, market internals, and other data.”

In other words, it’s not as simple as reading a stock market peak and declaring “the economy is about to decline” or observing a potential market bottom and declaring “the worst is over.”

Markets are increasingly affected by globalization and do appear to becoming more correlated as information reaches so many trading desks across the world simultaneously.

Also, with the proliferation of hedge funds as well as computerized algorithmic trading, the classic ‘purpose’ for investment (or trading) has deteriorated from what it was 20 or 30 years ago.

While funds do still invest on their belief about the future prices of equities, computerized trading programs and the open access to more market participants distorts these views.

Also, with the acceptance and rise in popularity of technical analysis methods, more traders are analyzing prices strictly due to mathematical indicators and visual chart patterns which seek to exploit certain aspects of market psychology of participants. Such trading creates unexpected and often unintended price movements which have very little to do with equity valuation or fundamental analysis. This further removes the link between the stock market and the economy.

This is a fascinating concept and I am glad Barry is addressing the point and sharing a few of his views.

As with most things in the stock market, nothing is as simple as it seems at first glance.

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  1. Stock Market » Blog Archive » Markets – Truly a Leading Indicator? Says:

    […] Afraid to Trade.com Blog wrote an interesting post today on Markets â?? Truly a Leading Indicator?Here’s a quick excerpt Barry Ritholtz at the Big Picture recently asked the question: “Are Markets a Leading or Lagging Indicator” which addressed the commonly held notion that markets lead economics (or financial conditions as they develop). Barry states, “There are so many varied inputs into equity markets — sentiment, trend, liquidity, momentum, valuation — anyone of which can be dominant at any given moment.  Merely assuming markets are giving you a 6 month heads up into the future, based on recent action, is o […]