February 21, 2012
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Recessions are notoriously difficult to forecast. That, of course, hasn’t stopped many high-profile analysts from predicting recessions in 2010 and 2011 – incorrectly, at least thus far. Given the wealth of often contradictory economic data that exists today on which to base such forecasts, this should come as little surprise. What’s more surprising, however, is that they have based their predictions on models that were ill conceived and insufficiently tested.
Among those pundits who have relied on faulty models are John Hussman, David Rosenberg and John Mauldin. I will examine some of the models they have used and then turn to a simple – but far more predictive – model that does not warn of a recession now.
Almost all recession forecasting is based on historical data and observing an indicator over time. A recession call occurs when certain patterns appear that have also preceded prior recessions.
I have developed an evaluation model that can assess how well various indicators have performed to date and assign each an effectiveness score. Appendix 1 has a detailed description of my scoring system, which uses official NBER recession dating to determine whether a call was correct or not. The maximum score is 1.00 for a perfect indicator. There is no downside limit for a bad one, but any score below zero raises serious questions about an indicator’s usefulness.
Armed with this assessment tool, let’s first look at a sampling of three recession indicators that have appeared in Advisor Perspectives commentaries.
The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) – or, more specifically, its growth figure (WLIg) – is a favorite indicator of many commentators. John Mauldin wrote about it on June 26, 2010, endorsing a view that when the WLIg falls as low as -5.7 – as had occurred at the time – it always, except for one occurrence, accurately signaled the past seven recessions.
Nothing could be further from the truth. From this assertion, one might expect the WLIg to be at or below -5.7% in the lead-up to each and every one of the past seven recessions. In fact, that level of the WLIg preceded only four NBER-dated recessions – those that began in 1970, 1973, 2001 and 2008. The WLIg never reached this level prior to or during the 1981 recession, and it got there only 9 and 12 weeks after the start of the 1980 and 1990 recessions, respectively.
What’s more, this indicator gave a false alarm in 1987 and at least one more since the beginning of 2010 – possibly a second, if a recession does not begin soon.
The chart below depicts this indicator’s history since 1968, with 5.7% added to the WLIg to place the trigger line at zero – hence, my shorthand for this indicator is WLIg+5.7. The blue line tracks the indicator’s value over time, while the shaded areas correspond to NBER-designated recessions.
This indicator WLIg+5.7 obtained a score of -2.331 from my evaluation model.
Another indicator referenced in John Maudlin’s June 26, 2010 commentary was the 13-week annualized growth rate of the WLI, which I will refer to as WLIg13. At the time, this value was -23.46%, which Maudlin called “very weak.” All prior instances where this indicator fell that low reflected a recession that was either imminent or already underway, Maudlin asserted, and he used the following table to illustrate his point:
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