Here is a brief excerpt from a classic article written by Tim Koller for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.

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Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.

What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic. And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.

They shouldn’t. The fact is that those markets, well analyzed as they are, don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and real economies, the credit markets can provide clearer indicators that a recession is on the horizon.

Collective wisdom falls short

Subscribers to the theory that markets process all information efficiently would argue that equity investors should be in very good shape to recognize early indications of a looming downturn. If that were indeed the case, current market valuations might inspire confidence. Our model of the equity markets suggests that their current levels in Europe and the United States are reasonably consistent with the intrinsic value of equities, given long-term profit trends and current rates of interest and inflation. And since equity markets do a reasonably good job of tracking long-term economic fundamentals,¹ investors can expect longer-term returns—dividends and share price appreciation—that are in line with historical real returns, in the range of 6 to 7 percent.

Of course, the fact that the stock market is currently in line with the long-term trend doesn’t rule out the possibility of major fluctuations on the way to the longer term. The performance of equity markets shows that they have not been a good predictor of past recessions. Indeed, during every major recession since the early 1970s, most of the decline in the S&P 500 index occurred after the economy had already slowed (Exhibit 1). For example, the major decline in the S&P 500 index during the 2007–09 recession didn’t occur until the third quarter of 2008, although the recession officially began in December 2007, and clear signs of problems appeared in mid-2007. Our analysis suggests that the equity markets give too much weight to current economic activity rather than to the situation likely to materialize in a couple of months or even a year.

Moreover, when the index’s value does drop during nonrecessionary periods, this rarely signals a coming downturn. In the past 30 years, there have been few major declines in the market outside of recessions (Exhibit 2). Even an extreme case, such as the 20 percent drop during a couple of days in 1987, didn’t portend a systemic downturn, and the index was back to normal a mere two months later. In the past, such market fluctuations have been caused mostly by forces that didn’t have anything to do with the real economy—and any effect they had dissipated very quickly. Equity markets played the more typical role of bystander, buffeted by and reacting to economic events rather than anticipating them.

While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times. Investors were able to go on buying and selling shares in most companies at reasonable prices throughout the crisis. During that time, the S&P 500’s long-term trend value—the value you would expect to see if you were confident that the economy would recover to its long-term trend within several years—stood at about 1,100–1,300. Therefore, no one should have been surprised to see a drop to the 900–1,000 level, given uncertainty about the depth and duration of the recession. Although the S&P 500 index eventually dropped below 900 in the first quarter of 2008, it didn’t stay there long; investors realized that a broad market level below 900 reflected unreasonable pessimism.

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Here is a direct link to the complete article.

Tim Koller is a principal in McKinsey’s New York office.