Wednesday, July 31, 2013

Quarterly And Yearly GDP Growth Rates Do Not Accurately Predict Following Year's GDP Growth Rate: S&P Index Is A Bettter Economic Forecaster Than Past GDP Growth Number

From The Wall Street Journal, "The Stock Market Beats GDP as an Economic Bellwether: The initial quarterly numbers are usually wrong—and they're poor predictors of future economic growth." by Edward Lazear:
The government's initial estimate of the previous quarter's GDP, the "advance" estimate, is followed by revisions in the two subsequent months, called the "preliminary" and "final" estimate. The "final" estimate is often revised again in subsequent months and years to yield the actual GDP number. It is quite common for there to be significant differences between the actual GDP number and the initial estimate.

The average quarter between 1996 and 2012 experienced growth at an annualized rate of 2.4%. In 26 of the 67 quarters that I analyzed, the advance estimate the BEA missed the actual rate of growth (reported much later) by at least 1.2 percentage points—half the actual average growth rate. In nine of those quarters, the initial GDP estimate was off by more than the average growth rate itself, e.g., off by more than 2.4 percentage points.
In fact, there is no clear statistical relation of a given quarter's GDP growth to the growth rate during the following year. A good leading indicator should at least predict whether the future will be better or worse than average. But knowing where the current quarter's GDP growth rate is relative to its historic average predicts correctly where next year's GDP growth rate will be relative to its historic average only 61% of the time. This is not much better than a coin toss. The longer run view is no better. Last year's growth rate does not predict with any statistical reliability next year's growth rate.

Market indexes are better predictors of GDP growth. My analysis of 1996-2012 shows that the performance of the S&P 500 relative to its average predicts the performance of the economy in the next year relative to its average a full three-fourths of the time.

Indeed, knowing the current quarter's GDP growth rate adds almost nothing to the predictive power of the quarterly change in S&P 500. For the purposes of predicting next year's GDP growth, we are better off ignoring the current quarter's growth rate altogether.

For every additional 80-point quarterly change in the S&P 500—which is the average quarterly change (up or down) during the period I studied—the market predicts about one-half percentage point of additional GDP growth during the subsequent year with statistical reliability. (Here, statistical reliability means that the correlation between future GDP and the S&P 500 could have arisen from pure luck with a probability of less than 3-in-100.)

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