Stock Markets - Predictors of the Future ?

As I was journeying on the bus and the MRT, I was thinking of how accurate the stock market is as a predictor of things to come. The market started its bear run in Oct 2007, and now Singapore is in a technical recession because of 2Q and 3Q 2008 GDP. So in a way, the stock market decline was able to "predict" the recession coming up and price it into share prices. This must be why people say that the stock market is a leading indicator, as it tends to react to future news and expectations even before they materialize and become apparent to the man on the street.

The reason for this uncanny ability of the stock market to anticipate economic slowdowns and recessions is due to the fact that most forward-looking news is incorporated into the price through investors/traders expectations of the future. Of course, there are some who argue that it might be a self-fulfilling loop created, whereby people's expectations of others' expectations forms either a positive feedback loop to push prices up or a vicious cycle (like what we are witnessing) to force prices lower. The analogy which Benjamin Graham used of Mister Market is extremely apt as stock markets are the collective actions of millions of participants, al trying to maximize their own gain and all thinking that they are (somehow) smarter than the guy next to them.

Normally, all this frenetic activity prices stocks very reasonably and fairly; and on "normal" days the market price can be said to be an accurate reflection of a company's intrinsic value. However, during periods of economic prosperity or depressive gloom, there is a tendency for the market price to over-shoot and land up too high or too low. Let me elaborate on this with respect to the current prevailing sentiment in the world. With the USA in constant fear of being "in a recession" and the rest of the world also afraid of tumbling into a long, deep recession; this has caused market prices to reflect the most pessimistic scenario, whereby many companies are priced as if they were better off dead than alive (below NAV !). This kind of weird asset pricing occurs in extreme conditions (admittedly, current conditions are unprecedented) and acts as a barometer of sentiment about the future (or the lack of one !).

The fear and trepidation is quite apparent in the last 3 weeks as the crisis has spiralled into something of an avalanche instead of being just a tiny snowball. On my blog alone, the number of visits has increased to more than 300+ daily (compared to 100-200 during the bull market and on normal market days). There are also seemingly more people acting sarcastic or cynical, which I may attribute to acute stress as a result of the sudden plunge in the value of their shareholdings. After some thinking and reflection, I realized that this is the PERFECT opportunity to purchase more shares in companies which I am confident in, and which can emerge from this crisis stronger. As a value investor, the idea is to own shares in good and growing companies, instead of relying on hindsight investing to tell if one should sell at the peak and buy back at cheaper prices (incidentally, anyone can be a hindsight investor by looking at a historical chart and sounding intelligent when they point out when you should have bought and sold; but try doing that in real time hehe). So the crux of the matter is to own shares in companies that will do well 3-5 years from now; the short-term price fluctuations do NOT matter as there is no intention to sell anyway.

Based on the above observation of the predictive abilities of the stock market, what I can say for sure is that the market will almost ALWAYS start moving up about 6 to 12 months from the recovery of an economy. This means that almost no one can accurately time the bottom as no one will know how long or deep the current recession will last. Stock prices are useful future indicators of how the economy will turn out; and investors who wish to own a piece of a great company should make use of this rare window of opportunity to purchase to his heart's content. Just make sure you leave enough funds for emergencies !