February 14, 2012
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At the end of September 2011, ECRI made a call that left the impression that a recession was imminent. Considering their track record of accuracy, very few challenged their argument. Two days later, the S&P 500 bottomed and rose an incredible 22% (through February 9, 2012) penalizing those who reduced their equity allocations based on ECRI’s forecast.
In December 2011, ECRI dialled down the urgency of the timing of their call to "within six months." That raised the question of just how much recession warning is useful when it comes to forecasting equity market performance.
It is understandable that long 9-12 month warnings would be useful for governments and some business leaders, but is this true for stock market participants? How many thousands of investors heeded the recession call and are sitting in disbelief on the sidelines in this rally (or were heavily hedged), wondering when the recession is going to arrive and vindicate their decision?
Many analysts dismiss the usefulness of co-incident indicators in recession dating, with the notion that by the time you realize a recession has begun, the horse has bolted. Therefore, the experts advise using leading indicators – and the longer the lead, the better. This seems intuitive, but is it really true? We can be far more accurate in dating recessions using short-leading and/or co-incident economic indicators, so why isn’t that the better approach?
Let us take a look at what history tells us from the seven recessions since 1967 – we’ll find some surprising answers. But first let me frame the methodology and analytics I will present. An illustrative example is the below chart, depicting the very first recession under review, which took place in 1970:
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