January 3, 2012
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A large number of reputable analysts and companies are forecasting a new U.S recession on the immediate horizon. Attracting the most attention is ECRI, which made a public recession call on September 30th and several television reaffirmations since. But an examination of a broader range of other composite economic indicators shows that sole reliance on ECRI’s forecast would be misplaced.
On a more recent video clip, ECRI’s CEO, Lakshman Achuthan, commented the recession could occur anytime within the next nine months. That would imply the call has a 12-month horizon from initiation. Indeed, a recession call 12 months out on the eve of the second year of an expansion is out of the ordinary if one considers the average length of post-war expansion of 61 months.
ECRI’s track record may be beyond reproach according to many of the investing community but in reality this call has a long look-ahead horizon. Moreover, we should be uncomfortable making investment decisions upon a single source, no matter how above-reproach the forecaster’s track record. Many people take the ECRI Weekly Leading Index (WLI) readings as on-going confirmation (or denial, as the case may be) of its call, given that the WLI is all that is publically available, but ECRI goes to pains to point out that their recession calls involve much more than just the WLI but a host of “long leading indicators.”
The ECRI Weekly Leading Index (WLI) on its own is actually one of the least reliable indicators for forecasting or predicting recession. My firm has taken 15 reputable U.S composite indicators that date back at least seven business cycles and comprehensively compared the National Bureau of Economic Research (NBER) recession dating prowess from a number of aspects such as false positive rate, AUC, NBER capture rate, and NBER lead and lag.. If one was predisposed to the use of a single indicator for making recession calls (not wise) my advice is to examine the freely available Philadelphia Fed Aurora Diebold Scotti Business Conditions Index (ADS) or the Chicago Fed National Activity Index (CFNAI) for more accurate track records.
Looking at paid-for subscriptions (although they make monthly readings available to the public) you can do even better with the e-Forecasting.com monthly LEI (eLEI) or their monthly GDP time series. All these indicators in an appropriate recession dating model capture 90% or more of NBER recession months with at most one or two false positives, whereas the WLI captures 75% at best with at least three outright false positives since 1968.
The argument, test-methodology and research regarding which single composite indicator is best at dating and forecasting recessions in another topic altogether, but the key is you can make far more informed and accurate recession forecasts with multiple indicators than with any single one on its own, regardless of which mathematical model you use.
Let’s examine our own forecast to provide an alternate view to those currently doing the rounds. The PowerStocks Research Weekly SuperIndexes are merely weighted indexes of nine popular and publicly available composite indices that provide a co-incident recession signal, a two-month lead recession signal and a five-month lead recession signal. They are composites of composites (super-composites); hence the term “SuperIndex.” The nine underlying composites and associated weightings used in the index were chosen on the basis of their individual recession dating/forecasting prowess (measured by many metrics) and are in no particular order:
- The Philadelphia Fed Aurora-Diebold Scotti Business conditions Index (ADS)
- The Philadelphia Fed Business Outlook Survey (BOS)
- The Conference Board Leading Economic Index (LEI)
- The Conference Board Employment Trends Index (ETI)
- The e-forecasting.com monthly Leading Index (eLEI)
- The e-forecasting.com monthly GDP series (eGDP)
- The Institute for Supply Management ISM Report on Business (PMI)
- The Chicago Fed National Activity Index three-month average (CFNAI-MA3)
- The ECRI Weekly Leading Economic Index (WLI)
The nine composites above result in about 28 updates to the SuperIndexes on a monthly basis as underlying data become available, but we publish an update weekly for subscribers. The relationship between the SuperIndexes and more recent NBER recessions and US monthly GDP output are shown below as at December 29, 2011 together with the probability of recession from a nine-factor multivariate statistical probability model. We can see the probability of recession within five months is a lowly 14.69%, a not-uncommon level for the latter stages of an expansion as shown in the 2001-2007 period.
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