Putting The ECRI Index Into Perspective

by: Jeff Gonion
Lately there has been a lot of attention given to ECRI's Weekly Leading Index (WLI), and its recent recession call. Kudos to ECRI on all of the free PR that comes from this. But apart from all the buzz, what should we, as investors, make of this?
Red Flag #1:

Looking at the ECRI report, it claims "...the U.S. economy is indeed tipping into a new recession. And there’s nothing that policy makers can do to head it off." Nothing? Really? Any type of sensationalism like this should always be cause for concern.

Are we to believe that ECRI has some sort of superior financial model that factosr-in all the possible actions that could be taken by policymakers? And that it can somehow predict the outcome of these decisions? I think not. If it had this ability, ECRI would have certainly used it to make trillions of dollars for itself, rather that attempting to sell its indexes and services to others.

ECRI's report goes on to brag about its past successes. Normally well-respected companies have no need to resort to such tactics.

Red Flag #2:

How is ECRI's WLI calculated? For this, we turn to ECRI's website: "The components of ECRI's composite indexes are proprietary." Wow... This too, should be cause for concern.

After all, the publishers of well-respected and reputable indexes, such as Dow Jones and Standard & Poors, make plenty of money publishing their indexes while being completely open about the formulation. This is because almost all leading financial institutions and news outlets are willing to pay these companies for their index data.

Take a Closer Look

So now let's take a closer look at ECRI's WLI.

The chart below compares the WLI to the Dow Jones Industrial Average, which is an index of only 30 companies.

Click to enlarge images

DJI vs WLIClick to enlarge

The similarities are striking. Just about every twitch in the Dow is mirrored in the WLI. If I didn't know better, I would think that the primary component of the WLI is the Dow. In fact I don't know better, because ECRI won't tell us how its index is calculated.

But what if the WLI and the Dow are both just responding to the same economic phenomenon? Perhaps ECRI's WLI is so sophisticated that it analyzes all of the economic behaviors that the market responds to, and reaches the same conclusions as the market.

Below is a chart of "Black Monday" 1987, where the stock market dropped precipitously for unknown reasons that are open for debate, but are commonly attributed to programmed trading. The conventional wisdom is that this was strictly a stock-market phenomenon, unrelated to any sudden drop in economic activity.

Black MondayClick to enlarge

As you can see, the WLI basically tracked the Dow. In fact, there is nothing wrong with this. The stock market is widely considered to be a leading indicator of economic activity. So it could very well be that the WLI depends on the Dow as a principal input. I don't know.

What I do know is this: You can't use the stock market to predict the stock market.

As investors, it is tempting to think that ECRI's indexes give us some insight into what the future holds. We think this because we want to think this. But the truth is that nobody really knows. We may tip into recession, we may avoid it.

In fairness to ECRI, it does point-out its recent recession call is not based solely on the WLI, but rather on the combined behavior of multiple proprietary indexes. This point seems to get lost by many bloggers and journalists along the way, who report on the WLI as if it tells us something important by itself.

ECRI might be right, or it might be wrong. But looking at the whole picture, claiming "And there’s nothing that policy makers can do to head it off," is still seriously over-reaching.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.