Trader Edge February Recession Model Forecast A Surprise

by: Brian Johnson Trader Edge

The following article updates the Trader Edge diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through February 2013.

Diffusion Index

The Trader Edge diffusion index equals the percentage of independent variables indicating a recession. There are a total of 16 explanatory variables, each with a unique look-back period and recession threshold. The resulting diffusion index and changes in the diffusion index are used to estimate the probit, logit, and neural network forecasting models.

The graph of the diffusion index from 1/1/2003 to 3/1/2013 is presented in Figure 1 below (in red - left axis). If you would like to view a graph of the earlier historical data (going back to 1960), please revisit A New Recession Slack Indicator. The gray shaded regions in Figure 1 below represent U.S. recessions as defined (after the fact) by the National Bureau of Economic Research (NBER). The value of the S&P 500 index is also included (in blue - right axis).

The percentage of explanatory variables indicating a recession dropped from 6.3% at the end of January to 0.0% at the end of February. None of the 16 explanatory variables is currently indicating a recessionary environment.

Please note that past estimates and index values will change whenever the historical data is revised. All current and past forecasts and index calculations are based on the latest revised data.

Diffusion Index 03-01-2013Click to enlarge
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Figure 1: Trader Edge Diffusion Index 03-01-2013

Recession Slack Index

The Trader Edge recession slack index equals the median standardized deviation of the current value of the explanatory variables from their respective recession thresholds. The resulting value signifies the amount of slack or cushion relative to the recession threshold, expressed in terms of the number of standard deviations.

The latest recession slack index value was 1.22 standard deviations above the recession threshold, up notably from a revised value of 1.08 last month.

The gray shaded regions in Figure 2 below again represent U.S. recessions as defined by the NBER. The median recession slack index is depicted in purple and is plotted against the right axis, which is expressed as the number of standard deviations above the recession threshold.

The dark-red, horizontal line at 0.50 standard deviations denotes a possible warning threshold for the recession slack index. Many of the past recessions began when the recession slack index crossed below 0.50. Similarly, many of the past recessions ended when the recession slack index crossed back above 0.0. The current value of 1.22 is comfortably above the warning threshold and the trend is positive as well.

Median Recession Slack Index 03-01-2013Click to enlarge
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Figure 2: Trader Edge Median Recession Slack Index 03-01-2013

While it is useful to track the actual recession slack index values directly, the values are also used to generate the more intuitive probit and logit probability forecasts.

Aggregate Recession Probability Estimate

The Trader Edge aggregate recession model is the average of four models: the probit and logit models based on the diffusion index and the probit and logit models based on the recession slack index. The aggregate recession model estimates from 1/1/2003 to 3/1/2013 are depicted in Figure 3 below (red line - left vertical axis). The gray shaded regions represent NBER recessions and the blue line reflects the value of the S&P 500 index (right vertical axis). I suggest using a warning threshold of between 30-40% for the aggregate recession model (green horizontal line).

The aggregate recession model probability estimate for 3/1/2013 was 0.0%, which was down from 0.1% last month. According to the model, the probability that the U.S. is currently in a recession is extremely remote. Given the reported GDP growth in Q4 2012 of only 0.1%, the model forecast might seem somewhat surprising.

Normally, flat GDP growth after a multi-year expansion would be cause for serious concern. However, the weak GDP growth in the fourth quarter appears to be a temporary anomaly and is not supported by trends in any of the explanatory variables.

There were two major drags on GDP in the fourth quarter. Business inventories were drawn down and not replaced during the quarter. During periods of economic growth, this typically leads to increases in inventory in subsequent quarters, which spurs future GDP growth. As a result, this effect may be temporary, rather than the beginning of a new trend.

Government spending dropped by 6.6% during the quarter, which further dampened GDP growth. The decline in government spending could have been due to anticipation of the sequester. This effect may persist if the sequester remains in effect.

Aggregate Recession Model 03-01-2013Click to enlarge
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Figure 3: Trader Edge Aggregate Recession Model 03-01-2013

Aggregate Peak-Trough Probability Estimate

The peak-trough model forecasts are different from the recession model. The peak-trough models estimate the probability of the S&P 500 being between the peak and trough associated with an NBER recession. The S&P 500 typically peaks before recessions begin and bottoms out before recessions end. As a result, it is far more difficult for the peak-trough model to fit this data and the model forecasts have larger errors than the recession model.

The Trader Edge aggregate peak-trough model equals the weighted-average of nine different models: the probit and logit models based on the diffusion index, the probit and logit models based on the recession slack index, and five neural network models.

The aggregate peak-trough model estimates from 1/1/2003 to 3/1/2013 are depicted in Figure 4 below, which uses the same format as Figure 3, except that the shaded regions represent the periods between the peaks and troughs associated with NBER recessions. The aggregate peak-trough model probability estimate for 3/1/2013 was 3.9%, which was up slightly from the revised value of 3.5% at the end of January.

Aggregate Peak-Trough Model 03-01-2013Click to enlarge
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Figure 4: Trader Edge Aggregate Peak-Trough Model 03-01-2013

Conclusion

U.S. recession risk remained very low in February, which is surprising given the reported +0.1% GDP growth rate for Q4 2012. The recession slack index was still comfortably above its 0.50 warning threshold and is trending higher. The aggregate model forecasts and diffusion index values were still well below their 30%-40% warning levels.

While the +0.1% GDP value in Q4 2012 was a surprise, trends in the entire spectrum of economic and market-related explanatory variables are inconsistent with past recessionary environments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.