Predicting Recessions: Identifying Reliable Sources

Predicting Recessions

We do not have a model for predicting a recession, nor do we claim any expertise at such predictions. Our strength lies in distinguishing the real experts from the pretenders. This is more difficult than it might seem, since recessions are an unlikely event, a subject we tried to explain. Anyone trying to predict unlikely events will have many errors. This leads the average observer to believe that there is no expertise involved.

That conclusion is a serious mistake.

Is Everyone an Expert?

CNBC has been posing the recession question to everyone. Is this just a matter of opinion? Is everyone's opinion equal? The way the question is posed carries this implication. It is as if they were asking about American Idol or Dancing with the Stars or what football team will do well this year.

We have noticed a clear trend. The less the responder knows about economics, the more likely the prediction of a recession. Those identified as "Chief Market Strategist" for some company are more likely to be worried and bearish. While economic opinion varies, the economists are more likely to see underlying strength in the economy and view the housing problem as a distribution of cases rather than a stereotype.

Econocator has two good articles (here and here) showing forecasts by economists. One should keep in mind that the average long-term recession expectation is about 20%.

The opinions of CEO's responding to CNBC interviewers and individuals answering polls is important, but not because they are expert forecasters. Their opinions are important because of confidence and investment plans. If everyone's investment and spending plans are governed by media hype on recession, there might be a self-fulfilling prophecy. CNBC today even held discussions speculating on the sad possibility that some hope for this. Watching CEO opinion and consumer confidence is important for this reason.

Bespoke Investment Group provides interesting data from Intrade on prediction market forecasts for a recession. Please note that the market sees a 7% chance of recession this year, defined as two quarter of negative growth. That means that Q307 must turn out to be negative!

The Range of Forecasters

The Bears. At one extreme there are the usual suspects: the long-time bearish market pundits. They cite the "spent-up" consumer, powerful symbolism like the "subslime contagion," and create long causal chains where one domino falls after another. The conclusion, in their view, is inevitable and unavoidable because they, knowing more than the Fed or anyone else, have foreseen this problem. They see the government generally and the Fed in particular as dumber and less informed than they are, concluding that the Fed is "behind the curve."

This viewpoint is argued effectively, vigorously, and repeatedly, getting massive exposure in the media and on the Internet. It has probably had a major effect.

The Error. The problem with these arguments is the arrogance of the approach. It is exactly the opposite of what we recommend. Instead of looking to find expertise, these pundits purport to see something that no one else knows.

In fact, every economist has been well aware of housing problems for years. The question -- still quite open for resolution -- is the extent of the effect on the economy--not stocks or credit markets--but the ultimate economic effect. These pundits argue that economists "do not get it." In fact, professional economists see the same evidence, but reach a different conclusion. Economists have all reduced economic forecasts to reflect housing issues and have done so for years. It is a question of magnitude.

The difference is that those with economic training do not view demand as a single point, but rather as a distribution. They do not see homeowners or lenders or borrowers or workers or employers as a stereotype, but as a distribution of actors.

When a business folds, jobs are lost. The workers do not all move to rocking chairs on the front porch. They seek new employment. Entrepreneurs develop new opportunities. That is why 2.5 million jobs are lost and created in our economy each month. Non-experts have no sense of the dynamism of the economy or the labor market. Astute readers should look for this awareness, and note its absence.

The Real Experts

There are many good economists, but a few days ago on RealMoney we highlighted a CNBC inteview with someone whose organization has the best long-term record on forecasting the business cycle.

Lakshman Achuthan of the Economic Cycle Research Institute was just interviewed on CNBC. His occasional updates are very important to those of us interested in economic analysis and forecasting. The ECRI has a great record that avoids "false positive" recession signals. They use proprietary leading indicators, but occasionally provide more insight into what they are seeing. Gary D. Smith also provides periodic updates on their indicators in his excellent Long/Short Trader column on RealMoney Silver.

The ECRI is not speaking for a sell-side firm nor trading stocks, so their comments come without any apparent bias. They sell their research, and they must deliver a quality product. Today's message? In answer to a question about the dramatic cover of Fortune, Achuthan made several interesting comments.

...the bottom line is that ...dramatic predictions get attention....(A)lmost every year there is a recession call. In 2002, 2003, 2005, 2006 and now in 2007, we are seeing various scenarios. You know some speculation and you kind of link it together. There is a housing crash therefore there must be a recession. Or there is a credit market shock and there must be a recession. That's not how recessions are made. ...(S)hocks can help trigger a recession but the economy needs to be vulnerable in the first place."

Explaining that the ECRI was always looking for vulnerability, Achuthan continued, "The events we have seen over the last few weeks and months have taken the shine off of growth out a few quarters, and we'll get some slowing.

He stated flatly that we would not get a recession this year. He also pointed out that economic indicators could only look forward a few quarters. The longest leading indicators show slowing growth, but he called it "way premature" to forecast a recession.

Asked about a leading indicator he pointed to the spread between AAA corporates and BAA corporates. Since he thought that viewers might not believe it, he picked one that you can look up yourself. "It is a good leading indicator....The spread was about 100 bp's before the credit drama started and now it is actually smaller...(I)t is a fifteen-month low in the spread."

I like the ECRI's rigorous analysis. It includes long historical studies to discover the best indicators. It emphasizes quantification. It shows a clear concept of what leads to recession. Readers would benefit from looking up the video up on the CNBC site and taking a few minutes to watch for yourself.

Conclusion

The astute investor must learn to be a wise consumer of information. We tried to highlight this dilemma in an article describing a typical CNBC interview. The comments from our readers were excellent, suggesting many good points and providing new data. After reading the comments, it is quite clear that an articulate advocate, using a stereotype, has a persuasive effect on the intelligent and informed viewer. That is the danger. The anecdotal example, effectively used, has real power--a power to mislead.

Readers should note that this is an article about education and understanding. It is not an immediate bullish market call. While we are bullish from a longer-term perspective, we are quite cautious about current conditions. It is a question of one's time frame. In particular, we are not convinced that the Fed shares the dominant market perspective on interest rate policy. Our technical models remain neutral/negative on the overall market, while still finding many attractive specific sectors.

The single most important takeaway: Beware of those claiming to know more about everything, seeing what no one else sees. A stronger approach is to identify and blend knowledge from true experts.

Comments

[DominoesFalling]

Obviously the bulls have reviewed the bears arguments and disagree but how do you explain the 50% decline in the housing stocks all the while the bulls are denying the dominoes lining up as predicted by the bears. How do you stop the dominoes of reverse wealth effect, mortgage resets, the solvency credit crunch and tighter credit with higer rates, the elimination of MEW (mortg. equity withdrawal), fewer leverage buy-outs and corp. buy backs, less foreign buying of any mortgage products, the falling dollar, less yen carry-trade, etc.etc. etc.

[aceemily]

Excellent article. There is so much info noise that it is difficult to separate the wheat from the chaf. It was good to know that there are independent pundits that use empirical data instead of a preconceived philosophy to give direction. This summation made for good reading.

[gordon]

The BLS was responsible for 81% of the "official" job creation ytd, all phantom jobs created to satisfy your "transit employment" element. How about TEMP WORKER numbers? They have never failed to lead those "official" payroll numbers, it says recession, so does retail sales, biz spending, here's accurate info.www.financialsense.com...

[Bob K.]

What is fascinating to me is how fast long term predictive models have broken down with those who have the most vested interest in their accuracy, the quants. And in all due respect to ECRI, who are probably the best econometrics firm, the models are on new ground. Money flows are moving at breathtaking speed and as we have just seen, and can seize up at a moments notice. How one can be so certain that there is no recession looming is not thinking through their risk/reward approach to investing. Oh by the way, you can lose alot of money in a growth recession, as well, think 2000.

[NoFate]

All harbingers of a recession:
1) As noted, temp worker numbers are a good indication.
2) How inverted the yield curve has been (3 month versus 10 tear).
3) New home sales has generally cross the 600 million mark as we enter a recession.
4) There are other good indicators as shown here:
www.econbrowser.com/ar...

All these indicators are moving in the wrong direction, though none are certain yet.

What are poor predictors of recession:
1) UE - it usually hits it's lowest point when the recession starts.
2) Last quarters earnings numbers ...they can turn on a dime.
3) Economists - They are notoriously bad at predicting recessions (and even bubbles for that matter - Shiller being the exception).

[NoFate]

Carlos - I don't disagree, except what you describe sounds more like depression ...I hope we don't end up there!

Also, by the time the government does something it is generally too late. It is common for the Fed rate to follow the GDP down, since the recession is generally "baked in" by that point and there is a lag in the affect of lower rate (probably 6-12 months).

Jeff - I think you got your answer. There are many recession indicators as the responders have pointed out. I think the bottom line is that not all recessions are the same. Some predictors are better than others depending on the cause and kind of recession. I try to triangulate ...or use more than one indicator.

I'm amused that Economists are such bad recession predictors though. Some economists seem to get it right most of the time, but most do not. I'm not sure if it is one of the following reasons or not:
1) Hate to be wrong.
2) Have conflict of interest with job.
3) Are too focussed on other economic studies.
4) Are not well educated.

I mean both "The Economist" magazine and the Federal Reserve studies put the probability at 30-40%, yet many Economists are so stupid they say there is virtually no chance of recession.

There is something rotten in Denmark!

[matt c.]

this is an interesting article, but, over the past couple of years, i think it's safe to say that the bears have been right a lot more often than the bulls have when it comes to the housing market and the economy.

as i see it, the debate about the housing market affecting the overall economy has gone something like this from BULLISH perspective:

1. "there is no housing 'bubble,' just a boom that's slowing down and will reaccelerate in the coming months."
2. "ok, there was a bubble in some select markets, but we don't see it affecting the US housing market as a whole."
3. "the US housing market was probably in a bubble."
4. "there aren't significant problems with subprime mortgages."
5. "there are problems in the subprime market, but they won't spill over into the market for prime mortgages."
6. "the subprime problems have spilled over into the market for prime mortgages, but we don't see this causing problems in the broader credit market or causing a general credit problem.'
7. "ok, we've had a credit crunch, but we don't see this causing a recession."

they've been wrong on steps 1-6. it is crazy to believe that they'll be wrong on step #7? i don't think it is. i'm not saying that a recession is guaranteed by any means, but, on balance, the bears, even the permabears, have been right more often than the bulls about the housing market.