Can the Stock Market Predict the Future?

They say the stock market is forward-looking.

They also say the stock market has predicted 9 of the last 5 recessions.

So which one is it?

Is the stock market all-knowing?

Or is it just as bad as any of us when it comes to seeing around the corner with what’s coming next?

It’s a little bit of both.

Chart Kid Matt has this great chart on his new blog that shows the stock market tends to bottom before earnings in a bear market:

On average, stocks front-run the earnings rebound by 9 months.

Just look at the 2008 and 2020 downturns to see how this played out in practice:

The stock market turned higher well before corporate earnings bottomed. The market saw the turnaround coming before it even happened!

This is one of the reasons it can be so difficult to invest in a bear market. The news keeps getting worse even when stocks start going up again. Everyone thinks it’s a dead cat bounce because earnings keep going down.

It’s a leap of faith buying during a bear for a reason.

You have to trust that the market knows something no one else does.

However, the stock market is not quite Nostradamus when it comes to picking the end of a bull market.

The stock market and earnings tend to peak around the same time when the bull market ends.

Look at what happened at the peaks in 2007 and 2020:

Stocks and earnings more or less run concurrently at the tops. There’s not much of a signal there since they both rollover together.

So the stock market is better at predicting bottoms than tops.

No one’s perfect.

This is what makes investing equal parts interesting and difficult.

Investing when stocks are down requires a leap of faith because you have to assume the market knows something the headlines don’t.

And investing when stocks are up requires a leap of faith because you have no idea when the rug will get pulled beneath your feet without warning.

This is one of the reasons stocks offer a risk premium over other asset classes.

If investing in stocks were easy, you wouldn’t earn high returns over the long run.

No risk, no reward.

Further Reading:
How Bear Markets Work