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Recession: Just How Much Warning is Useful Anyway?

February 14, 2012

by Dwaine van Vuuren

For each NBER-dated recession, I will assess percentage decline from the most recent pre-recession high of the NYSE as shown by the black line. NBER-dated recessions are defined as the month following the business-cycle peak through to the trough I will determine four measures, namely P2NBER (how many months elapsed from the NYSE peak to the first month of recession), DROP1 (how much the NYSE declined in the P2NBER months), NBER2T (how many months elapsed from the first month of recession to the NYSE correction trough) and DROP2 (how much the NYSE declined from the first month of the recession to the NYSE trough).

The conventional wisdom tells us that the stock market leads the business cycle by six to nine months, and therefore DROP1 should be much larger than DROP2 – the earlier your warning the better. The results of this exercise are tabled below:

What jumps out is that the conventional wisdom held until 1973 and then underwent a dramatic change, with the stock market becoming much timelier in signalling recession, which can be seen in the dramatic fall in the number of the months in the P2NBER column.

Perhaps the stock market and recession forecasting/dating techniques and models have become much more sophisticated, and that is what has caused this fall in the lead between when the stock market peaks and onset of recession. If we include the 1970 and 1973 recessions, then the analysis tells us the stock market peaks 7.3 months on average before the onset of recession. But if we exclude these two recessions, the average drops to a mere 4.8 months with a 3 month standard deviation.

Assume an investor is following a business cycle expansion buy-and-hold strategy, where the aim is to remain vested in the stock market for as long as possible before the onset of recession. Any defensive action longer than 4.8 months on average before a recession is going to be counterproductive for him or her. Think about this – in the 4.5 months since ECRI's recession call the stock market has rallied more than 22%. Is that counterproductive enough for you?