Friday, April 27, 2007

When Do Stock Market Booms Occur?

Today, I bring to you a few snippets from (along with my encouragement for you to read) the following paper:

When Do Stock Market Booms Occur?
The Macroeconomic and Policy Environments
of 20th Century Booms
Michael D. Bordo
David C. Wheelock
Working Paper 2006-051A
September 2006

Given today's GDP report, I believe that this is a timely look. It's always a good thing to start with the abstract, which I provide here:

"This paper studies the macroeconomic conditions and policy environments under
which stock market booms occurred among ten developed countries during the 20th Century. We find that booms tended to occur during periods of above-average growth of real output, and below-average and falling inflation. We also find that booms often ended within a few months of an increase in inflation and monetary policy tightening. The evidence suggests that booms reflect both real macroeconomic phenomena and monetary policy, as well as the extant regulatory environment."
The goal of my post is to share some things that I found of particular interest, rather than provide any insights that are beyond my capabilities. All direct material is in italics. Any text emphasis, unless noted otherwise, is solely my own.

The study design was interesting in that the authors looked across several countries: Australia, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, United Kingdom and the United States. Part of this look was to isolate variables that contributed to the booms and find correlations. As you can imagine, due to rather significant changes in the regulatory environments, to include foreign exchange policies, in addition to availability of essential data, the authors amended their study design accordingly. Here was their goal in that design: "Our multi-country historical approach enables us to explore the association between stock market booms and key macroeconomic and monetary policy variables across a variety of policy regimes and regulatory environments." (p. 3)

What the authors find is that booms are procyclical (no surprise there!)-- "booms generally occurred during periods of above-average economic growth and below-average inflation, and that booms typically ended when monetary policy tightened in response to rising inflation" (p. 4) Yet, they also note that the market is not just affected by the economy but rather were sensitive to "changes in regulation and other events, such as oil price shocks and political upheaval."(p. 2).

For those of you who've been reading for a while, you know that I'm intrigued my the notion that stock market crashes are causal to economic downturns AS OPPOSED TO forecasting economic downturns. Therefore, you will understand, then, why I found the following of interest:

"Bordo (2003) finds that many, but by no means all U.S. and British stock market
crashes of the 19th and 20th Centuries were followed by recessions. A serious decline in
economic activity was more likely, he concludes, if a crash was accompanied or followed by
a banking panic. Mishkin and White (2003) come to a similar conclusion in their review of
U.S. stock market crashes in the 20th Century. They find that a severe economic downturn
was more likely to follow a crash if the crash was accompanied by a widening of interest rate credit spreads. The key lesson for policy, Mishkin and White (2003) argue, is that
policymakers should focus on the financial instability that can arise in the wake of crashes,
rather than on crashes per se." (p. 3)

Given with my (unhealthy?) preoccupation with systemic risk coupled with my belief in the words of the more conservative opinion makers that risk is NOT priced into the market and that leverage is at unprecedented levels, I found the widening of interest rate credit spreads language interesting. Why? Because the credit spreads have been narrow. Granted, the credit spreads for the mortgage loans have widened lately, but the corporate bond spreads have not. (I'll admit that my comment is a bit general).

Through this historical, multi-national look, the authors find "considerable coincidence in the occurrence of stock market booms across sample countries" (p. 6). Today, as we look across the many markets, including our own, that are at all time highs, we can posit that we are yet another empirical data point that substantiates the authors' conclusion (their study stops at the 2000 boom).

There are a few aspects of the study design that I'd like to share. With regards to a "boom", "there is. . . no precise empirical definition of an asset boom" (p. 4). The authors "identify the maximum and minimum observations of the real stock price within rolling, 25-month windows. We require that market peaks and troughs alternate, and so eliminate all but the highest maximum that occurred before a subsequent trough, and all but the lowest minimum that occurred before a subsequent peak. We classify as booms all periods of at least three years from trough to peak with an average annual rate of increase in the real stock price index of at least 10 percent. We also classify as booms a few episodes of exceptional real stock price appreciation that were shorter than three years."(p. 5) Note the emphasis on real rather than nominal stock price. Using real prices, that is prices that are adjusted for inflation, takes the inflation noise out. I couldn't help but wonder how this study would be affected if all of the prices (among all countries) were stated in a constant unit of measure--for example the price of gold, or the price of oil. If so, perhaps some of these countries with weakened currencies (our own?) would not be classified as having a boon.

Some other discrete points:

  • "Real GDP growth exceeded its long-run average during a majority of stock market
    booms. . .Thus, the typical boom arose when output growth was above average and rising, and ended when output growth stopped increasing. (p. 10) [US growth is currently slowing];
  • In a look at the 1929 crash, the authors note, "Other authors, such as Galbraith (1955), emphasize the rapid growth of investment trusts and commercial bank securities affiliates in the 1920s, and their role in enticing unsophisticated investors to the market." p. 13 [I found this interesting give our ETF and investment trust boon in contemporary times.];
  • Relative to the post 1929 bust, the authors note: "Currency devaluation and/or the imposition of restrictions on gold convertibility was a precursor to economic recovery in many countries (Eichengreen, 1992)." (p. 15) [Note that contemporary commentators point to devaluation as making American goods look cheaper, but we don't manufacture very much anymore. Additionally, the strengthening of the economy during this time is not something that you hear too many gold-centric people talk about.];
  • "Booms tended to occur during periods of above average output growth and below average inflation." (p. 16);
  • "Almost all booms were followed by real declines of at least 10 percent within 12 months. Not all booms ended with a spectacular crash, however, and the lengths and sizes of market declines after booms varied widely." (p. 6).

As we look at contributing factors to both booms and busts, what are we to surmise relevant to current times? I've often been flummoxed by the amount of disagreement among experts as to where we are in any economic cycle. So regardless of agreement or not on causal factors, seemingly simple questions regarding the economy (actual GDP without all of the qualifiiers and revisions) often have answers that draw sharp disagreement among expert. The authors conclude that

  • "stock market booms were an element of the business cycle, with booms typically arising during cyclical recoveries and other periods of rapid economic growth and ending when GDP growth slowed."(p. 25);
  • "Many stock market booms were followed by large declines in real stock prices, if not outright market crashes, and a slowing of economic activity." (p. 25)
  • "Booms typically arose when inflation was low and declining, and ended within a few months of an increase in the rate of inflation. Rising inflation tended to bring tighter monetary conditions, reflected in higher real interest rates, declining term spreads, and reduced moneystock growth." (p. 25)
  • "We speculate that financial deregulation and globalization weakened the links between domestic economic growth and stock markets in the 1980s-90s." (p. 26)
As we look at our own times, can we say that inflation is low and declining? I'm not sure-it depends on who you ask!. Can we say that productivity is increasing? No, it is slowing. Is growth slowing/declining? Yes. Squawk box had Ellis and Tulley on this a.m. (Business Week and Fortune editors) and they were rather dour. I was surprised by both their point of view and their consensus! They also noted that with slowing productivity, that businesses will have to increase their cap ex, and that of course, will lead to declining bottom lines. Can we say that monetary conditions are tightening? No, they are not--so that is the wind under this stock market airliner's wings. Also, I think that real interest rates may still be low. These two factors--continued increasing money supply and continued low REAL interest rates--are the two critical factors that when/if reversed, will pull the rug out from all of our markets. It's also worth noting that currency dynamics could also be a contributor to a market jolt OR continued moves upward as we have active carry trades.

I certainly do not know how to weight the import of one factor over another, but I found the article to be very helpful in developing my understand of market booms and busts, most particularly in the contributing factors.

I hope you gleaned a useful point or two from this.


russell120 said...

I have used that paper as backup for a variety of arguments about current market conditions.

It also dovetails in well with "Unexpected Returns: Understanding Secular Stock Market Cycles" by Ed Easterling. This book (along with your Zurich Illuminati Book?) is also found over on Barry's list.

Note the importance of inflation. It is one of the reasons that a strong economy does not always correlate with a strong market.

Leisa said...

Russell--I should have known that you would have already memorized the paper! The Easterling book looks good. I think that every investor needs to understand these cycles; which is why I frequently send folks to Dagnino's site.

Thanks very much for this reference.

russell120 said...

I forgot to mention that he has a website.

The charts here on historical stock market returns are particularly interesting: they are not as high as people think.

Leisa said...

MarkM gives us some examples of historical comparisons as well. I provided the GMO website in my previous post. I hope that you check it out.

Anonymous said...

The Easterling book is excellent. Crestmont's numbers on average returns for the Dow versus compounded returns is an eye opener. All investors should memorize this.

Leisa, you keep bemoaning your bearishness. Losses KILL returns. If you have a full cycle left before you withdraw your long term investment monies, there is no logic in rueing the "loss" of short term gains. None. In the NEAR UNIVERSAL majority of cases, it is all given back. Every penny. All you have to do is look at the charts.

Everyone thinks that The Bear of 2000-02 was a one off event. Wall Street certainly wants you to. No, it was caused by an 18 year bull that went parabolic in TMT and large cap growth. Even if it hadn't gone parabolic, a Bear would have ensued and 50% of the gains would have been given back on average. Again, the charts say so.

This recovery rally has been a very weak bull market. Why? Conditions are not right. Certainly the growth is not organic. Normally you would see three years or so of 20+% gains to kick off the bull. Not this one because PEs never got back to trend even after 3 years of declines! They were interrupted by unbelievable policy stimulus. It continues today.

You are correct that monetary policy is STILL too accomodative. That is why the Fed Governors trotted out those comments late last year and early this about flexible targeting. THAT was the signal that they could not control inflation here and they knew it. A big tipoff for those who were listening.

This is a gamesmanship market. Shortsqueezing, pumping and dumping, relentless index arbitrage. It disgusts me. Pure bacchanalia. But I am long and wishing it would end because I am positioned to outperform BIG TIME on a decline. Until then I must share Grantham's temporary "pain" of underperforming the indices but outperforming on a risk adjusted basis. Right now I am getting 2/3 of the gains but a decline would scarcely touch me if I have this figured right.


AngelaV said...

This is an interesting article. Thanks for sharing it. I like reading and exploring another site that offers insightful analysis of many so-called facts and other myths about the market at

I particularly like their "Guru Grades" area which ranks many experts against their published writings.

Take care.