Shares don’t operate in a vacuum. Sure, sometimes stocks seem to have a mind of their own, partly because automated computer trading plays a far bigger part in price moves nowadays. But stock markets are actually much smarter at forecasting the future than many of their critics think.
And when equity prices fall a long way fast – and economic surveys go very bearish – it generally means something serious is about to hit the ‘real’ world.
So, are the major stock market declines of August 2011 warning us that the next recession is on the way? And if so, what will that mean for your portfolio?
Computers have made share price volatility worse
You may well have heard the old joke that the stock market has forecast the last ten out of the two most recent recessions.
Put another way, share prices move up and down much more, and a lot faster, than the ‘real’ economy. If we get spooked at every 10% fall in the FTSE 100, we’d end up needing financial shock therapy. Yet even the most battle-hardened traders will have been shaken to the core by the markets’ savage volatility this month.
Partly it’s the result of more computer-driven trading in stock markets than ever before. High-speed traders use supercomputers to find discrepancies in stock prices. Then they use this data to buy and sell shares ultra-fast – sometimes in tiny fractions of a second. This can make price swings bigger than they otherwise would be.
So with maybe as much as 75% of current volume being high-speed trading, we can pin some of the blame for the recent volatility on the machines, or at least the people who programmed them.
But markets are still sending out a big warning
But don’t be fooled into thinking that the recent big falls can just be written off as irrational and irrelevant. They’re neither. It may have taken longer than we’d expected, but markets have now twigged that the chances of another global recession are rising fast. And this one could be just as nasty as, if not worse than, the last one.
Most of this will come as no surprise to MoneyWeek readers. My colleague James Ferguson has been warning for a long time that economies worldwide “haven’t resolved any of the outstanding issues. The eurozone periphery is still insolvent. The recovery elsewhere looks…weak enough to appear vulnerable to a sharp slowdown. Banks across the globe are still in trouble”.
James’s comments, by the way, were made in the magazine back in January. What, though, has given investors worldwide the willies within the last week? After all, plenty of business and consumer surveys have been dropping hints for months that economic growth is soon set to slow, with the US leading the way down.
Here’s the clincher
Last week’s gob-smacking news from the US ‘Philly Fed’ was the clincher. The Business Outlook Survey from the Federal Reserve Bank of Philadelphia, to give it its full title, is a monthly survey of manufacturers in the region.
Since May 1968, respondents have been giving the lowdown on trends in their businesses ranging from employment, working hours, new and unfilled orders, shipments, inventories, delivery times, prices paid, and prices received.
That’s a pretty comprehensive list. And while the Philly Fed isn’t an infallible indicator, history shows it’s been a good proxy for business activity across the States. In turn, America still accounts for almost a quarter of world GDP. So a serious sign that a US new recession is looming there would be bound to affect the rest of the planet.
And as David Rosenberg at Glusken Sheff notes, the latest Philly Fed reading was far worse than expected – a “real shocker. Without going into the gory details, almost every component was negative – not just down, but below zero. Never before has the Philly Fed been at this level without there being a recession. This is a one in ten event, and consistent with a 90% chance of outright recession”.
Take a look at the chart below. This tracks the Philly Fed – the blue line – compared with US GDP – in red – over the last 43 years. I’ve ‘advanced’ the Philly Fed by three months to show its predictive power.
 
Source: Bloomberg
(Click on the chart for a larger version)
In a word, ouch! Particularly after the earlier news from the widely watched University of Michigan US Consumer Sentiment Index preliminary report for August. This hit its lowest point since 1980.
Again, this result was far worse than forecast. It shows how high food and fuel prices along with slow wage growth are squeezing over-indebted American consumers, who still account for a sixth of global consumer spending. So we will all feel the adverse effects.
Add it all up, and a US double dip, which will drag the rest of the world into recession again, is looking very much on the cards.
George Soros summed it up yesterday. “Financial markets have a very safe way of predicting the future – they cause it”, he has just told Der Spiegel. “If a double-dip recession was in doubt a few weeks ago, it’s less in doubt now. The markets have decided that America is going to see a recession.”
So what would a return to recession mean for your portfolio?
As we said last week, forecasting the next move in the markets is well nigh impossible. The chances are, though, that stocks are still facing further falls ahead. But if you’ve positioned yourself in the kind of defensive stocks that don’t need economic growth to make their money, you can sleep a little easier.
Sure, the stocks you hold can still fall. But blue-chip defensive high-yielders won’t go bust in a recession, and meanwhile they’ll pay you a decent income. So we still stick by the sort of ideas we tipped here: What to buy when the Greek bail-out rally fades.
And market volatility will mean trading opportunities. On this score, here’s a quick reminder about our spread betting pages. They’re packed with details about how to trade, with lists of spread-bet brokers too.
Now spread betting isn’t everyone’s cup of tea, because it’s clearly more risky than making long-term investments. But to help guide you through, why not take a look at what our spread betting and trading veteran John C Burford, has to say. He gives plenty of tips three times week. What’s more they’re free. If you haven’t done so yet, sign up to his MoneyWeek Trader email.
Category: Economics