February 14, 2012
Now for the big surprise: DROP2 is much bigger than DROP1 – almost double! That hits most seasoned investors and clients we have showed this to right between the eyes. If you use any number of well-crafted models that are based on coincident indicators (and there are brilliant ones, including some we have built), you are still likely to avoid two-thirds or more of any recession-related correction. (This assumes, of course, that you time your re-entry to stock market trough perfectly – but we have to assume the two methods will re-enter at the same time when evaluating optimal times to exit.) This stylized fact is not isolated – in five of the seven recessions, this was true, and for the two it was not, DROP2 was not that far from DROP1. Timing exits with co-incident indicators is hardly a worthless approach.
Obviously, it is ideal to exit 4.8 months before recession (on average). But it is not crucial and arguably, unless your leading indicator is dead accurate – which cannot be guaranteed – it is possibly not ideal,unless it has a short lead.
Given the far better dating accuracy one can achieve with statistical models deploying short-leading and/or co-incident indicators, you ignore them at your peril. I say this as many respected leading economic indicators (the ECRI WLI being one) have been whipsawed with false positives of late. One ought to hesitate in basing high-stakes decisions – which is what acting on recession calls are – solely on leading indicators.
Co-incident indicators reflect the real economic reality, whereas leading indicators predict. Co-incident is always going to emerge the winner in the "measure the real economy" contest. That is why statistical models for dating recessions using co-incident indicators are generally more accurate in pinpointing exact start and end dates of recession. Even the NBER itself officially uses a set of co-incident indicators to proclaim recession, not leading ones, although admittedly it does so 8 to 12 months after the fact.
Of course, by their nature co-incident indicators will never offer advance warning, as leading indicators do. But that is not such a huge shortcoming, since their improved accuracy and relatively small one-third loss of efficiency in a high-stakes game still makes them a player in any self-respecting recession model or approach.
By all means use leading indicators, but be aware that risking an entire exit or hedging strategy on leading indicators alone, especially long-leading ones, may not offer the best risk-adjusted approach.
Heading for the hills more than five months before recession is more likely to be counterproductive than not, assuming you are following a business cycle expansion buy-and-hold strategy. Do not isolate your decision points to LEIs only, since they can be subject to false positives and they only give you an extra 33% edge. Coupling or staging your actions with recession models that use more accurate short-leading and coincident economic indicators will allow you to still capture up to two-thirds of the benefit of timing market exits, while greatly enhancing reliability.
Dwaine van Vuuren is CEO of PowerStocks Investment Research, a South African-based provider of investment research. If you would like to receive the next 4 weeks SuperIndex Recession Reports for free, just email us at with FREE SUPERINDEX AP2 in the subject line.
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