Stocks don't react early to a recession - new evidence

 

A traditional view is that stocks are forward-looking and can provide early insight on a downturn in the economy. Significant empirical evidence has shown counter-cyclicality between equities and macro-aggregates. However, new evidence suggests that stock prices reflect the onset of a recession but with a delay. It is a matter of properly measuring the business cycle. (See "Late to Recessions: Stocks and the Business Cycle" This delayed response means that the business cycle itself provides information about equity return and not the reverse. Equity returns are predictably negative after the onset of a recession before turning positive. There is strong momentum during a recession while there are mild reversals associated with discount rate changes during expansion.  

Equities under-react to a business cycle downturn. Hence, there is the opportunity to form trading rules that will add alpha and increase the Sharpe ratios from active equity trading around business cycle events. This value-added all revolves around the ability to measure or assess regime changes in the business cycle. This measurement is not immediately intuitive but there is known modeling technology that focuses on regime switching that can be used to exploit macro opportunities.

The author shows that even a simple trend with macro downturn model will add value and account for the combination of market downturn with the autocorrelated behavior in equities.

The true useful extension of this paper is connecting regime changes with the time series behavior of stocks. Expected returns can be forecast through using a state-dependent autocorrelation model. 

Exploit trends during contraction periods and account for reversals in expansionary phases. The intuitive explanation for this equity behavior is that investors are often late in reacting to a recession, that is, investors are poor at adjusting their forecasts to an impending downturn.