There are people who believe the stock market predicts recession and because of the recent fall, there is trouble ahead. They may be right to believe there is trouble ahead but they would be naive to believe the stock market predicts it.
In 2008 economist Paul Samuelson pointed out that the stock market had predicted nine of the last five recessions. In medicine it is called a false positive. Of little value but a clear connection to confusion.
The stock market provides but one outcome. The auction price of particular securities. To attribute more outcomes denies its structure and purpose.
Being an auction it could point out that people are fearful or greedy, but that would require the necessary step of understanding the value of the security. Under conditions of fear and greed, the value and the price become disconnected. Relying on price for more information than it contains is a fool’s game.
The thoughtful investor will work hard to discover if the current fear is well founded. The investor may discover that it is and be able to estimate the timing and effect of what is learned. That is actionable information. Alternatively the investor may discover that Mr. Market is in his depressed state and is offering bargains to the skilled.
Recessions and other economic events tend to be created by actions of the various players in the marketplace. It is Like W. Edwards Deming’s idea that in a business, defects are designed into the product and design can remove them. Beware of ill-conceived government responses to trivial events or to the lobbying of selfish players. There is a strong argument that the 2008 crash arose primarily because the government tried to make mortgage financing more available to people with weak credit.
The fault of one government policy
The 2008 financial crisis was the result of four converging elements, all linked to a single U.S. government policy: an attempt to increase mortgage credit for low-income borrowers by forcing Fannie Mae and Freddie Mac—the two government sponsored enterprises (GSEs) that were the principal buyers of residential mortgages—to reduce their underwriting standards. The policy, known as the affordable housing goals, was adopted in 1992 and was pursued through two administrations until 2008.
The banks and others responded to incentives and regulations. This result is not the first or the last time that government largess failed to provide the benefit intended.
The lesson is if you wish to invest successfully you must pay the price. You must be aware of the investing environment, you must understand how the economy and businesses works, you must be aware of governmental effects and you must understand and govern yourself.
A tall order. But quite rewarding. The first step is to understand and invest in businesses not pieces of paper with a number connected to it. (stock certificate) By doing that you will know two things. When it is safe to buy and when it is foolish to continue keeping it.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.