Market Knows Best

The financial markets—and the investors who populate them—seem to hang on each announcement of key macroeconomic indicators. Unemployment. Industrial production. Gross domestic product. A calendar full of cues to buy or sell.

But most initial reports of macroeconomic data are highly inaccurate. They undergo significant revisions in the months and sometimes years after their initial release, being ultimately adjusted by as much as 200 percent, according to new research by Thomas Gilbert, an assistant professor of finance at the University of Washington Foster School of Business.

Importantly, if the initial reports are inaccurate, Gilbert’s study reveals that the market knows the true score.

“Hundreds of thousands of investors comprise the market,” he says. “And each holds some piece of information about the economy—employment, consumption, production—at a given time. These distributed pieces of information get aggregated into prices in reaction to the day’s macroeconomic announcement, which itself is usually inaccurate.”

The markets’ response is related not to the initial release, but rather to its final revision.

“By aggregating all the dispersed information of the economy,” Gilbert adds, “the markets can forecast the future revisions of this macroeconomic data.”

Predictive in any economy

Gilbert analyzed the daily returns of the S&P 500 Index following the announcements of key macroeconomic reports over the past 25 years. He focused on three major indicators that undergo significant revisions: the monthly releases of non-farm payroll and industrial production and the quarterly release of GDP. What emerged was an empirical relation between announcement day returns and the content of eventual revisions.

This link differs across the business cycle, Gilbert finds. Announcement-day stock returns and future revisions are positively related in expansions and negatively related in recessions.

But in either economic climate, the returns are predictive.

The financial impact of this revisionist trading can be dramatic. For instance, Gilbert calculated that an eventual single-month revision of 100,000 jobs in the employment report is equivalent to an average announcement-day change in the S&P 500 Index’s market value of $10 billion during an expansion and $43 billion during a recession.

To put this in perspective, the average error in the monthly jobs report is 250,000 people. During a recession that could mean an announcement-day swing in the S&P 500 Index’s market value in excess of $100 billion.

Chalk it up to the power of aggregation, millions of independent investors contributing their personal perspective and knowledge of the economy to a prescient market.

The market’s efficiency

The influential “efficient-market hypothesis,” which asserts that share prices always incorporate and reflect all relevant information, took a beating during the global financial crisis. But Gilbert sees his latest findings as evidence of the hypothesis in action, at least in the market’s rational response to inaccurate macroeconomic announcements.

“This result is in strong support of market efficiency,” he says. “The market is capable of aggregating accurate information about the overall economy that no individual personal or organization can know at a given time. A lot of people hold small pieces, but only the market knows the whole.”

In this case, the market knows best.

What, then, is the point of collecting macroeconomic data, at great expense, and releasing it in the endless cycle of macroeconomic reports? Gilbert describes each announcement as a catalyst for the truth to emerge, expressed in the dispassionate form of market prices.

“There is value in incorrect information,” he says. “The release forces a crystallization of this dispersed knowledge of the economy that only the market can aggregate. Without the announcements, there wouldn’t be an event that forces the market to form this aggregate opinion.”