To predict turning points with a degree of certainty requires an investment in economic research and forecasting expertise - or sheer luck, writes Michael Casey
THERE IS a vague sense out there in the ether that the Irish stock market is oversold - that it should not be as low as it is. Many potential investors would dearly like to be among the first to spot the green shoots of recovery.
Some investors have recently expressed the view that the equity market may not start to recover until unemployment rises to a higher rate. In other words, they are taking unemployment as an indicator of when the economy bottoms out. They might well be right to take this view; nobody really knows what influences share prices or indeed what indicators are the best predictors of economic trends.
In fact it may not even follow that a recovering economy always means that the stock market will recover. Stock markets are much more influenced by psychological factors, especially herd instincts, than are real economies.
There may, however, be some reason to expect the Irish stock market to recover before the real economy. The indicators that suggest this might include the money supply; the low price/earnings (P/E) ratios of Irish stocks; the low market value relative to companies' asset value; and informed statements made by the Financial Regulator and the governor of the Central Bank.
The money supply has been growing rapidly in the Eurozone. This means that many people have substantial current accounts and deposits in banks. At some stage depositors are going to go back into equities, especially if they feel that there are bargains to be had. The low P/E ratios and other metrics would suggest that there may well be bargains. This view has probably been reinforced by recent official statements.
The Financial Regulator expressed the view that undeserved comments about an Irish bank were deliberately spread by a speculator who stood to gain from short selling. More recently, the governor stated that Irish banks were well capitalised, robust and did not have toxic products on their books.
Statements like these are even better than leading indicators because they directly address investor fears. Such statements are also made without any axe to grind.
If interest rates were to fall further in the US or Europe this would embolden investors even more. At lower interest rates they would have an incentive to withdraw deposits and invest in the stock market.
Equities have given much higher returns over the long term but can also generate losses in the short term - nobody can be certain when the time is right to invest. It is a question of the individual's appetite for risk and it's unlikely that any one indicator will reduce perceptions of risk by much.
The property market will probably take longer to recover and people will be reluctant to buy houses until they think the bottom of the cycle has been reached. They will also be reluctant to buy shares in companies that provide household goods until such time as the property market recovers.
The unemployment rate might not be the best indicator of when the economy hits rock bottom. If immigrants go home, for example, the unemployment rate may not increase all that much. It would be better to look at net job creation. But even if net job creation were to fall below zero would that necessarily mean the recession had hit rock bottom? Or that productivity was going to increase?
There are of course many other indicators. An important one to look at is the construction of new houses. Another sign would be an increase in mortgage lending, while another indicator is retail sales. This gives a feel for consumer spending which accounts for about 60 per cent of GDP. As well as this there are surveys of consumer confidence and of "footfall" on shopping streets. There is also good data on car sales, while government VAT receipts usually indicate how consumer spending has been moving. There are other indices on manufacturing and agricultural output, foreign direct investment, exports and imports. Most can be accessed from the CSO website.
If an investor examines all of these indicators in the hope of spotting the green shoots of recovery, he or she should be aware of the following complications: the stock market and the real economy do not always move together; what might look very positive to the untrained eye may not have much significance. Statisticians call this "noise", or in common parlance "one or even two swallows may not make a summer".
If price deflators do not exist it will be difficult to evaluate what a particular number actually means in real terms. There are many technical problems, ranging from base effects to seasonal adjustment;Ireland is a very open economy and is strongly influenced by international trends making a vast array of international indicators also relevant.
It would be virtually impossible for any individual to sort through these and extract the important signals and it is probably best left to economists who specialise in forecasting, to analyse the indicators, domestic and foreign. The Economic and Social Research Institute (ESRI) and the Central Bank produce forecasts every quarter, do not have any vested interests and have good forecasting records.
In conclusion, there are no magic green shoots or indicators that prove recovery is just around the corner. There are hundreds of different indicators each with their own health warnings. To predict turning points with any degree of certainty requires a large investment in economic research and forecasting expertise - or sheer luck.
