Amidst all the talk of a recession, this chart presents something of a puzzle. It shows that there's a decent correlation (0.57) between annual changes in the All-share index and in UK industrial production*.

The puzzle is that this correlation is contemporaneous. If stock markets anticipated recessions and booms, we'd expect to see the blue line move in advance of the red one. But this isn't really the case**. Sure, the strongest correlation (of 0.68) comes if we lag industrial production four months. But such a short lag might exist simply because the stock market is a "jump" variable whereas output isn't. Shares can respond immediately to bad news (such as the collapse of Lehmans in 2008), but because output takes time and must be planned in advance, it can be slower to respond.

For longer lags, the correlation is weak - for example, it's only 0.23 between price changes and output changes 12 months later.

This lack of a significant lead between share prices and output is especially surprising simply because you'd expect one simply because changes in share prices can cause changes in output - via cost of capital or wealth effects, or because share prices should send signals about future economic conditions.

So, what explains it?

I don't think the story here is about equities: my second chart shows a very similar relationship between output and sterling's trade-weighted index.

Instead, all this is consistent with a simple possibility - that stock markets just don't see recessions coming (or at least don't anticipate the things that trigger recessions). We know that economists have consistently failed to foresee recessions. Perhaps this isn't (just) because of their own inadequacies. Maybe it's because economic fluctuations are inherently unpredictable.

This could be because recessions are the product of complex emergent processes. But there might be a more mundane reason. If some recessions were predictable, policy-makers would loosen policy in advance, thus preventing them***. The only recessions we ever saw would then be the unpredictable ones.

The message I take from this is that we should be humble about our ability to foresee recessions coming, especially when others aren't expecting them.

* Given that UK equities are correlated with overseas ones, and UK industrial production with global output, I suspect a similar pattern is true generally.

** The chart is also inconsistent with Samuelson's quip that the stock market has predicted nine of the last five recessions. If this were the case, we'd expect to see some falls in share prices which aren't followed by falls in output. However, except in 2003 (and maybe now!) we haven't.

*** They would then be criticized with hindsight for loosening policy unnecessarily!