It has been mentioned several times here that stocks (S&P 500 index) predict the economy six months in advance. What about interest rate spreads, do they look forward six months in advance?

To test both ideas I looked at stocks' six month prior return before a recession started as defined by NBER. I defined this as the predicted "start" of the recession. I also looked at the six month change in spreads of Moody's BBB index to 10 yr Treasurys. I used the last nine recessions (first one in 1954) and assumed we have begun the 10th one.

Further I defined the predicted middle of a recession as the period from start to six months before the recession ends. Not all recession have a middle as the 1980 recession lasted only six months.

Finally, I predicted the end as the period six months to the end of the recession.

My hypothesis: If the markets "predict" a recession to start six months prior, returns should be negative for stocks and the spread change should be positive (spreads increase). Likewise if the recession is to continue. And opposite if it is to end.

The table displays the results.

.             Predicted Predicted
.                 by           by          Overall
Predicting Spreads    Stocks        Count

Start         7             7              10

Middle       6             6              8

End           3             8              9

While most of the hypothesis seems solid, it would seem that  credit risk continues to increase even with the recession ending.

I will leave it to the reader to calculate the magnitude of the changes. It is tricky partially because the "start" of the current recession, if there is to be one as I assumed, is not yet defined; and the magnitude of change of prior 6 months greatly depends on the starting month, but not so its being negative.

But to whet the readers appetite, the starts totals changes are not too large in size. The middle is bigger and so are the ends.

And since the scale of the current spread increase and stock decrease is the largest of these, let me refute a meme. It appears that the prior 9 spread change magnitudes at the start had a negative correlation ( r ^2 near 50%) to length of the recession. Perhaps because if the spreads did not predict a recession the dead weight dragged down the economy, but if it did predict and raise competitive cost to borrow, the dead weight died quicker and better capital allocation speeded the recovery. Further, the stock magnitude correlation was near 0.

As noted both indicators are currently more pronounced than the prior 9, so clearly in some ways "this time it is different". But the implication would seem the opposite of the meme from the press. And as for the analysts, let's remember they had a vested interest in keeping the markets booming in the dot com days, as their left hand had a great thirst for leverage and risk then. Perhaps now, with their left hand deleveraging and shunning risk, they would like stocks to remain cheap till they can participate again.

James Sogi adds:

What is so amazing is the speed from which just a little over a year ago the markets were at an all time high and all seemed so rosey. Then so suddenly everything turned so sour in everyone's mind and the entire system seemed so at risk. A good example is the speed of the decline in Iceland. There certainly is a wall of worry in place. The last big bull run started with a bang, literally, even if it didn't shock and awe the Iraqis. Things looked pretty bad in March 2003, and the crash had wiped out many. One of the characteristics of the last bull run was the low volatility, and the steadiness of the rise, such that buying almost any drop was a winning strategy. Perhaps a retrospective thing to look at is when the market started to go up in relation to the end of the recession.

Sushil Kedia comments:

The Hindi movie superstar of yesteryears — Rajkumar — immortalized in the movie Waqt (meaning time) the line that translates to roughly, "Trees that refuse to bend lower will break down".

If the markets, economies and hoi polloi in general knew that there existed a large unresolved credit problem and still markets were being pushed higher and higher it could very well be that the last skeptic (read the permabear) was being cleaned out. Once achieving the minimum possible pessimism the time varying nature of variance then goes on to catch up (sic down) in a hurry. Trees (read: price structures) that weren't agreeable to bending lower in a timely fashion were then forced to be broken down with time.

Memetics, discussed and mentioned earlier, is about acknowledging that a meme shall prevail until it has got the largest possible number of believers. And so, while things are hurtling lower for now, it too could be that the inertia of observing minds will prevail on a pessimistic mood while prices (the new meme) would uncoil ahead of the perceived economic environment.





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