The Market's Take on Recession
Saturday, January 12, 2008
Every day there are dozens of talking heads that come on TV and give their opinion about the odds of the US economy going into recession in 2008. For the most part these opinions are pointless and you're best off just ignoring them. Why? Because we have an excellent tool, a trading market, that can tell us with more better certainty, the likelihood of particular events occurring. That market is called Intrade. If you haven't heard of it, check out this quick introductory video:
The theory behind the predictive power of a market is simple: since there is real money at play, people will only make a bet when they possess enough information to make an informed decision. For instance, in an opinion poll, a person might have absolutely zero clue whether candidate A or B will win an election, but they will probably tell the pollster something anyway, and since there is nothing on the line, there is no penalty if they are wrong. If, on the other hand, the pollster asked the person if they would be willing to bet $50 on their candidate if they could win an additional $50, the person probably would choose not to answer. Thus, when real money is on the line, opinions will be backed by much more confidence.
So does it work? Sure. Las Vegas odds-makers and trading markets like Intrade are consistently better predictors of future events than opinion polls. Like any market, certain events might be "overbought" or "oversold" at any given point, making for interesting trading opportunities, but the theory is that in the long term these anomalies will be sorted out by arbitragers trying to make fast money. And like any trading market, the results are updated in real time as money flows into and out of these contracts and information becomes available.
Anyway, back to the purpose for this post. With some talking heads on TV screaming that recession is imminent and the end is year, and other blowing it off and saying we have absolutely nothing to worry about, where does the market stand? As of the time of my writing this, the bid/ask spread for the recession contract is 58.5/59.0 - in other words, you can buy a contract for about 59 dollars - and if the US enters recession in 2008, the contract pays out 100 dollars. Or, if more information becomes available and the market increases the risk of recession to 70 or 80, you can sell the contract before expiration and pocket the difference.
From a historical perspective, the market thinks the chances of US recession in 2008 are about as high as ever. Nevertheless, even in the high 50s, the current opinion certainly isn't a mandate either way. Keep an eye on the Intrade markets, as you trade stocks and options for insight into how those securities could move. For instance, if you think financial stocks are getting beaten down because the market is pricing them for US recession, check the Intrade contract, it might turn out that the market isn't pricing in recession as much as you thought, and these stocks might have more room to fall before you should jump in.
Posted by Rob Pitingolo 6:10 PM
