Why Stocks Lead the Economy at the Turns

Every stock price is two numbers multiplied together. One is the earnings investors expect. The other is how much they’ll pay for each dollar of those earnings, the price-to-earnings multiple. Change either, and the price moves. At the turns of the economic cycle, the second number usually moves first, and that is most of the reason stocks turn before the economy does, since a multiple can change on a single shift in mood while the earnings it applies to take quarters to show up in a report.

Price as a product

Write it down once and the rest follows.

Expected EPS comes from analysts’ forecasts and from what investors think of them. The P/E is looser. It rises when investors feel the earnings ahead will grow, become more certain or be worth more because interest rates are falling, and it falls when they start to worry about any of those going the other way. The multiple is where hope and fear show up in the price.

Prices rise while forecasts fall

Now take that company into a slowdown. Analysts cut their forecasts, and next year’s expected EPS drops 10%, from $5.00 to $4.50. On its own, that would take the stock down 10% at an unchanged multiple. At the same time investors start to look past the slowdown. They see signs it may be ending. So they’ll pay 18 times earnings for the recovery they expect, up from 16.

The forecasts fell 10%. The stock rose. Nothing irrational happened: investors were paying more for earnings they expect to recover, and that shift in the multiple more than offset the cut to next year’s forecast, which is the mechanism behind a market that turns before the economy.

The same thing at the top

The mechanism runs in reverse near a peak. Forecasts are still rising, since the economy is strong and companies keep beating estimates. But investors begin to doubt it can last, and they pay less for each dollar.

A stock that falls while its forecasts rise looks like a mistake from the outside, when what it shows is investors paying for the next phase of the cycle before it arrives, and paying less for a strong year they think will not repeat.

The practical use for your own holdings is modest. When a stock you own moves against its news, split the move into its two pieces, the change in expected EPS and the change in the multiple. Near a turn, the multiple often did most of the work.

Leads are irregular

Prices moving first gives you no timetable. Sometimes stocks turn well ahead of the economy, sometimes only just ahead, and sometimes they fall hard on a slowdown that never becomes a recession, and in each case the cause is the same change in what investors expect, arriving on its own schedule. There’s no fixed lead to count from.

False starts happen too. Investors can bid up the multiple on a recovery that doesn’t come, and when the data keep getting worse, the multiple drops back and takes the price with it, sometimes to below where the rally began. A rally in the market is a change of expectations. Expectations can be wrong.

That’s why a rising market on its own can’t tell you that a recession has ended, or that one is starting. It tells you what investors believe this week. Traders who try to label the phase in real time keep running into this problem, which is the argument in the viewpoint on naming the cycle stage. A related idea, the market regime, describes the conditions you trade in without claiming to know what comes next.

Stocks aren’t the only market that moves early. Lenders reprice risk on the same expectations. The bond market has its own gauge of worry, the subject of credit spreads and sector returns.