Unexpectedly Intriguing!
August 2, 2006

Chris Dillow observes and wonders:

Good judges, and the yield curve, reckon there's a good chance of a US recession. This chart shows one reason why this matters - in recent years, there's been a close correlation between industrial production and the S&P 500.

This is surprising. Common sense says markets should see recessions coming, so share prices should discount them in advance.

So why don't they?...

My thinking is that investors discount forward looking data for as long as possible because they can't predict when the market as a whole will get hit by the cluebat. Up until that point, it's actually rational for many investors to stay in the market for the sake of maximizing the value of their investments. In other words, a game of chicken for stock market traders and investors.

One good example is that of the U.S. stock market's recent "discovery" of increasing inflation in the U.S. economy. Even though it was repeatedly pointed out and evident that this measure was rising above desirable levels as early as September 2005, for whatever reason, market psychology is such that it didn't factor into stock prices until the following May.

After all, why bail when you can still make good money until the cluebat begins swinging?

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