Monday, 22 August 2011

Look out for more surprises

In March I argued in a blog post that the stock markets were setting themselves up for a fall. I used the opportunity to explain how to use the Economic Surprise Indicators as some kind of composite indicator that has at least some value in predicting the future market mood.

An Economic Surprise Indicator measures if data releases are on average better than, in line with, or worse than consensus estimates. The indicator reached a peak in March this year and has been falling in a straight line ever since. This is pretty much in line with my explanations of 5 months ago, and certainly, the markets have heeded the call:

“Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, we will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.”

The question is where we are now, 5-6 months later? The Economic Surprise Indicator nosedived as the economy began to slow. Somewhat belated, stock markets found out on 1 August and we have had quite some market mayhem since then.

Economists and Analysts are beavering away on their forecasts of economic growth and company earnings. We are seeing a wave of downgrades. The term “Recession” is back in fashion. At the same time the Economic Surprise Indicator has stabilised at a very low level, indicating that economic surprises are still negative.

The indicator is not the answer to everything. But once the wave of forecast downgrades are over – and believe me, the downgrades will be aggressive – the market will suddenly begin to receive positive surprises. The most likely result is that the current negative sentiment will change. Market participants will convince themselves that it is not quite as bad as they thought. The “hidden factor” in the equation is to understand that the underlying consensus estimates are moving as a result of positive or negative surprises.

The important thing here is that in order to stabilise the market sentiment, it does not matter that we are looking at 5 years of below trend growth. It matters that the market somehow adopts it as a consensus. At that point in time, risk willingness will increase again.

When it will happen? I don’t know for sure. But it is typical that a cycle from exuberance to despair and stabilisation takes some six months. So sometime in September, maybe. Or it could be that downgrades are dramatic enough to stabilise sentiment earlier. 

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