It is said that equity markets can tell the direction of the real economy with a lead of six to twelve months. This has two main reasons, one is that most central banks do not participate in the market and the second is that flows generally start moving in the direction that the real economy would witness hereon.
The first reason is the correct and one of the only assets that central bank except few intervene. This keeps flows within the investors that are driven by the estimated trajectory of the economy.
But the main battle becomes reality against these estimates. This is the major driver of the direction of the market. The more the reality beats the estimates the higher number of upgrades leading to more inflows and lower shorts with vice versa when the reality is below estimates.
These estimates are built on the interest rate cycles that the economy is in. When the rates are being lowered these estimates look more positive that is why valuations go way beyond logic and when rates are hiked these estimates fall similarly.
The difference this time is twofold, one is that inflation, as a factor does not have any weightage in these estimates. Second, the pace of rate hikes is so quick that the impact on these estimates varies monthly.
These two factors make the past six and next six months a trap. This means that these factors are such extremes that a slight relief in any one will impact the estimates with wild swings resulting in a high level of volatility till one of them reverses with a sustainable direction. That is why it is wise to follow reality for some time.
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