Is the Stock Market a Leading Economic Indicator?

Paul A. Samuelson wrote in 1966: “The stock market has predicted nine of the last five recessions”. But the eminent economist sarcasm was not sufficient to end that indicator reliability as a leading indicator of business cycles turning points.

 

To be retained as a leading indicator, a variable must have a significant importance in the economy. It must also pass the test of time: having historically demonstrated that it precedes by a few months the economic cycle peaks and troughs. Stock prices, even if they fluctuate for many reasons, seem to satisfy those conditions for many economies.

 

At the OECD, stock market indexes are recognized as one of the leading indicators for 27 of the 39 countries for which this organization calculates monthly composite leading indicators. The Conference Board publishes monthly leading economic indexes for 12 countries and the euro area; only the index for China does not include the stock market as a leading indicator. The Japan Cabinet Office, the Conference Board of Canada and Desjardins also retain stock prices as a leading indicator respectively for Japan, Canada and Quebec economies.

 

Moreover, the authors of box 1.3 of the IMF September 2011 World Economic Outlook ask the following question: “Are Equity Price Drops Harbingers of Recession?” To answer it, they looked at the G7 countries. Their methodology and their analysis showed that for the United States, the United Kingdom, France and Japan, “… from the first quarter of 1970 through the first half of 2011, …real equity prices in these economies are useful predictors of recessions.” They add: “For Canada and Germany, there is no evidence that equity prices aid in predicting recessions, whereas for Italy, their predictive power is consistently superseded by the inclusion of additional financial market variables.” The authors conclude that: “These findings suggest that policymakers should be mindful of sharp drops in equity prices because they are associated with an increased risk of a new recession.” 

 

Then, even if they are not infallible, stock prices indexes are legitimate leading indicators for many economies.

 

Link to the OECD list of leading indicators by country: http://www.oecd.org/std/leading-indicators/CLI-components-and-turning-points.pdf

 

Link to the Conference Board Internet section on leading economic indicators:

http://www.conference-board.org/data/bci.cfm

 

Link to the September 2011 IMF World Economic Outlook:

http://www.imf.org/external/pubs/ft/weo/2011/02/