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The Markets and Recovery Scenarios

By Michael Burke, B&M Research

Financial market operators are well used to the markets adapting to changed circumstances much sooner than forecasters. As a result, much greater weight is placed on the performance of leading financial markets as indicators of future economic activity than is placed on consensus forecasts among economists. After all, the near-unanimous view among economists was that 2001 was set to see another year of strong growth. So, now that stock markets have rebounded from their lows and long-term interest rates are rising, market operators are adjusting their expectations towards economic recovery, even if the forecasters are slow to catch on.

The widespread and well-rehearsed argument is that, now that stocks have rebounded from their September 21 lows, an economic recovery is sure to follow. As far as it goes, this must be true at some point. However this only tells us that there must eventually be a recovery, not when it will be, still less that it is imminent. Some financial market pundits have generally contented themselves with the notion that the rebound in global stocks is the harbinger of economic recovery, on the grounds that stock markets are always forward-looking and always rise ahead of recession’s end. In this way a circular and (for sell side analysts, self-serving) argument is established: Stocks rise before recovery – Recovery is on its way – It’s time to buy stocks.

However, the gap between a rebound in stocks and recession’s end can be as long as 17 months, so there is little information generated by the current rebound.

An alternative method of relating movements in stock prices to the business cycle is to look at both the duration of the stock market slump and its depth, versus the trajectory of GDP.

One potentially significant statistic is that 2001 marks a second consecutive annual fall in the leading stock markets. This is quite rare and a glance at the previous periods when the DJIA has fallen in consecutive years may provide a clue as to its significance:

Stock Market Slumps & GDP


*assuming 2002 sees a rise in the stock market

** est. change in industrial production

Source: B&M Research

The first point to note from the table is that three consecutive years of declining stocks (in nominal terms at least) is an extreme rarity, either associated with economic slump or with the extreme uncertainties of war. Even two consecutive years of stock market falls is sufficiently rare to suggest that a major dislocation has occurred. However, even if we leave aside the war periods, when war-production was responsible for a rise in GDP but investors took fright, there is still no clear-cut relationship between the depth of the market downturn and the (lagged) downturn in the economy.

Of course other factors need to be taken into account other than the magnitude of the fall (response of other financial markets, prior degree of stock market overvaluation, etc), but it does provide an antidote to the current Wall Street view that economic recovery is just around the corner.

Yield Curve History

A similar note of caution is applicable to the recent back-up in bond yields. The mainstream, widely-held view of the bond market focuses much more on the recent rise in bond yields and steepening of the yield curve, which are widely interpreted as evidence that the economic recovery is already underway. Certainly, some of the economic data has improved.

However, if the full extent of this downturn still lies ahead, then both the current level of yields and the shape of the yield curve hold little economic information about recession. In addition, the history of the most severe recessions provides no uniform pattern on the trends in the yield curve.

In the table below we show the US yield curve during the most severe recessions of the last century, as well as the most recent trends. For the sake of long-term comparison, the yield curve is measured using the discount rate and the yield on long-term AAA-rated corporate debt.

The Yield Curve in Severe US Recessions

(AAA Long-Term Yields Minus Discount Rate, bps)


Source: B&M Research, data supplied by

National Bureau for Economic Research

This curve has been both positively-sloping and inverted at the onset of recession, and has moved in both directions during recession. The sole consistent point is that the curve is once more positively-sloping at the end of recession, as would be expected given the role of the yield curve in helping to recapitalise the banking system.

However, there are few other conclusions to be drawn from this history. At the same time, the inversion of the government yield curve is a faultless predictor of recessions, never having falsely signalled a recession that did not later materialise, and never having missed a recession by remaining positively-sloping ahead of the downturn. This is unlike the stock market, which, before the current fad for investing it with such strong predictive powers, was often derided for having “predicted seven of the last two recessions”. Crucially, the US government yield curve became inverted in March 2000 and only turned positively-sloping once more as the Fed began to cut rates at the beginning of 2001. With the normal time lags in operation, this would imply that the US recession will last until the end of this year.

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