The stock market has been surging to new highs almost daily, driving down dividend yields and price-earnings ratios skyward. Is this bullishness justified? The careful investors want to know if the economy is really going to do well enough to support these high stock prices.
What do the economists forecast?
- Will the real GDP increase over the next four quarters?
- Will the growth be at a healthy rate?
- Will there be a recession in the next year or few years?
- Even if a recession occurs, will it be brief or prolong?
- What will corporate profits (one of the major factors driving stock prices) be in the next year or 3 years?
The lesson is that the markets and the economy are often out of sync. It is not surprising that many investors dismiss economic forecasts when planning their market strategy.
Quote: 'The stock market has predicted nine out of the last five recessions!' (Paul Samuelson)
Quote: 'I'd love to be able to predict markets and anticipate recessions, but since that's impossible, I'm as satisfied to search out profitable companies as Buffett is.' (Peter Lynch)
However, do not dismiss the business cycle too quickly when examining your portfolio. The stock market still responds quite powerfully to changes in economic activity. Although there are many 'false alarms' like 1987 when the market collapse was not followed by a recession, stocks almost always fall prior to a recession and rally rigorously at signs of an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy.
This is no easy task, however. To make money by predicting the business cycle, one must be able to identify peaks and troughts of economic activity BEFORE they actually occur, a skill very few, if any, economists possess. Yet business cycle forecasting is a popular stock market endeavour not because it is successful - most of the time it is not - but because the potential gains are so large.
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