Hurray! The Recession Has Ended! (Old News)

This week we saw a report from Federal Government officials suggesting that they had seen evidence suggesting that the recession might have ended in August. While this is clearly good news for anyone affected by the recession, I would submit that this revelation is really old news. The stock market “knew” about this back in March. This is one of the unusual (some might say “perverse”) aspects of the stock market – it tends to “discount” or “price in” events/developments well in advance of their actual occurrence. Another strange aspect of the stock market’s apparent ability to forecast the future is that it generally does so about six months out. So it is not surprising (looking back with perfect hindsight) that the stock market in March was looking out six months (to September) to assume that the recession would end by then.

Recall, if you can, investor sentiment at that time. As the market found its bottom in early March, investors were extremely worried. By then, the cataclysmic market gyrations of October and November had been replaced with a slow and steady decline, truly notable exactly because it was not being driven by newer and bigger bad news. The market had simply acquired a putrid air about it. It was an undead market slowly shambling to its own ignominious demise. Many investors, like so many B-movie villagers, had fled in droves. Many market strategists and analysts (who perhaps should have known better) were telling investors to sell all stocks and hold cash. So the idea that the recession would end in August or September was not obvious to most observers.

How does the market know about the future? Does it have some kind of magic crystal ball? First of all, there is really no physical entity called the “stock market,” per se. The stock market is simply an abstract concept which incorporates all of the investment opinions, decisions and sentiment of the world’s investors. You can think of it like one of those photo mosaic pictures – it looks like one thing at a distance, but upon closer inspection, is really made up of many small things. There are stock market indices, like the Dow Jones Industrial Average and the S&P 500 Index, but these too are simple aggregates of a bunch of stocks.

It is this composite nature of the market which gives it the ability to “see” into the future. The best and perhaps smartest investors clearly and fully understand the concept of risk, and they are willing to take a few steps into the darkness with the expectation that this assumption of risk will be adequately rewarded over time and in accordance with the laws of probability. This understanding of risk coupled with the ability to measure value allows the professional investor to invest long before the reasons to invest become obvious. Investors who wait for hard, irrefutable evidence before investing will generally be disappointed with the results.

The market can discount the future because the smartest investors out there are anticipating possible future outcomes long before they seem likely.