New York - One of the great Wall Street parlour games is trying to divine what the stock market is telling us about the future of the economy.
That's especially true in a market like this one, which is down sharply for the year, the occasional daily uptick notwithstanding. After all, the thinking goes, if today's stock prices reflect what investors are willing to pay today for a stream of future earnings, there's a macro-economic message lurking in there, right?
Probably not. No, I'm not going to use the old line about falling stock markets having predicted 11 of the past five recessions. Instead, I'll show you how little weight is accorded to stock prices by serious economists whose job is to estimate the future course of the economy. I'm talking about the Conference Board Leading Economic Index, often known by its former name, the index of leading economic indicators.
The Standard & Poor's 500 stock index is, in fact, one of the 10 factors that Conference Board economic techies use to construct the Leading Economic Index, which we'll call LEI from here on. But the S&P's influence on the LEI is remarkably light.
Month-to-month changes in the S&P account for only 3.97 percent of the change in the 10-factor LEI. By contrast, changes of average weekly hours of manufacturing workers account for 27.41 percent of the change in the index. And average consumer expectations for business conditions tallies 14.59 percent.
The S&P ranks eighth of the 10 factors, ahead of only two other factors, both of which are frequently treated like some sort of economic divining rod: average weekly initial claims for unemployment insurance (3.29 percent in the LEI) and building permits for new private housing starts (3.10 percent).
How can popular news-making indicators such as the S&P, unemployment claims and housing starts rank so low on the index, with a combined weight less than the spread between federal funds and 10-year Treasury securities (11.15 percent)? “The LEI is an objective and reliable tool for forecasting the economy,” Ataman Ozyildirim, the Conference Board's director of business cycles and growth research, told me. Stock prices, he said, “are a very important indicator, but they're very noisy” and often reflect herd behaviour and momentum, as opposed to rational assessments by investors looking at projected future earnings and asset prices.
The Conference Board really goes out of its way to mitigate the impact of the S&P on its leading indicator index. Rather than comparing the S&P's closing price on the last day of January with its close on the last day of December to calculate a month-to-month change, it takes the closing prices on each day of January, divides them by the number of trading days that month and compares that average with the average for all the trading days in December.
That minimises the impact that a high or low month-end close would have on the index. I don't pretend to understand how the Conference Board has come up with the 3.97 percent number it uses for the S&P, or for the numbers it uses for other LEI factors. Ozyildirim offered to take me through the process, but I was afraid it would make my head explode.
What I do understand, though, is that stock prices, at 3.97 percent, rank very low in the hierarchy of leading economic indicators.
The bottom line: We media types fill a lot of space and airtime speculating about what stock prices are supposedly telling us about the economic future. It's attention-grabbing and a lot of fun. But it in the end, it's not information. It's just noise.
THE WASHINGTON POST