With the recent surge in stock prices, some analysts believe that the probability of recession is receding.
Figure 1 shows the evolution of real GDP and the S&P industrials since 2000.
Figure 1: Log real GDP, SAAR,Ch.2000$, (blue) and log nominal S&P Industrials index, last month of quarter (red). NBER defined recessions in gray. Source: BEA NIPA release of 27 September 2007, IMF International Financial Statistics, and NBER.
The argument that higher stock prices would presage faster economic growth makes a lot of sense. Since stock prices are the present discounted value of the future stream of expected dividends, an increase in anticipated economic activity — and hence earnings and dividends — should be associated with a boost in the stock market. In this regard, looking at detrended real output and real S&P industrials is instructive.
Figure 2: Log real GDP, SAAR,Ch.2000$, (blue) and log S&P Industrials index, last month of quarter, deflated by GDP deflator. Both series detrended using Hodrick-Prescott filter applied to full sample, using default lambda parameter for quarterly data (=1600). NBER defined recessions in gray. Source: BEA NIPA release of 27 September 2007, IMF International Financial Statistics, NBER, and author’s calculations.
One has to be wary about detrending — in this case I’ve used the Hodrick-Prescott filter, which has its detractors (see e.g., Cogley and Nason, JEDC, 1995). With that caveat in mind, note that in general detrended output follow detrended stock prices.
The notable exceptions include 1987, when stock prices rose, as output fell, and when stock prices collapsed in Black Monday, output rose. Another exception is the run-up to the 1990 recession; in that case stock prices rose relative to trend up until the recession.
Different detrending techniques would probably lead to different results. However, the main (and fairly modest) point is that the stock prices are an imperfect indicator of recessions and booms.
What to think of the most recent rise in stock prices? Returning to the characterization of stock prices as the present discounted value of dividends, one is reminded that the required rate of return on equities is also part of the formula — and the drop in the Fed funds rate is clearly important here. In other words, a lower Fed funds rate, to the extent that it reduces the rate of discount for equities, could mean that stock prices are a particularly misleading indicator of the market’s expectations of the future state of the economy.