In the current issue of Barron's Mike Santoli has some special insight for those trying to interpret the many historical analogies making the rounds. He writes:
• Every time the U.S. unemployment rate has risen by at least 0.3% in a month, as it did in December, a recession has occurred. So a recession is a sure thing.
• Prior to the onset of recession, there's typically at least a 25% one-year rise in weekly unemployment claims. The increase in claims in December was less than 7%. So a recession is not imminent.
• But, then: The average decline in the S&P 500 from a pre-recession peak to a trough since 1945 has been 25%, just a few percent more than the index had lost from its 2007 peak to its intraday low Wednesday of last week. So, maybe the market has mostly discounted a typical recession scenario?
• Hold on, because a bearishly inclined forecaster suggests that in recessions, 70% of the prior bull market's upside is undone, implying another 20% or so downside risk from today's levels. Scared yet?
• Not so fast, because every one of the 23 times since 1987 that the ratio of bears to bulls in the weekly American Association of Individual Investors poll has exceeded two (as now), the market was up 12 months later, by an average of 21%.
Such evidence of history's malleability is almost enough to make us all post-modern, and deny that any objective reality exists. More to the point, it's a little different every time, and the key is to figure out that difference.
These observations are excellent and the thoughtful followers should read the entire column. He reaches a conclusion that will be familiar to our readers:
But stocks have already been repriced to reflect expectations that published estimates are too high. The current S&P 500 forecast could be chopped by 10% and still market valuations wouldn't appear extreme at current prices. But the market's real-time response to muted corporate outlooks will deliver the true verdict on whether the market has built in enough fear.
The pricing of stocks compared to expected earnings and bond yields is our definition of a negativity bubble.
Barry Ritholtz, citing the Santoli column, offers some great advice for interpreting data. He provides a list of questions--really good ones-- that anyone should ask. Once again, readers should check out the entire article.
Applying the Ritholtz Advice
As we read Barry's advice, we immediately thought of many current "recession indicators". We tried to illuminate this problem with an earlier article on the problems inherent in forecasting unlikely events. Let us try to apply the advice in this context, using several questions from the list.
- Do we have enough historical examples? For recessions, the answer is clearly "no." There are not that many of them, especially in recent years. It is easy to tinker with a system to achieve a perfect retrospective model.
- Causation or correlation? For recessions, many of the economic variables are concurrent or lagging indicators. Most analysts look at directional movement versus absolute levels. For example, unemployment claims are not close to prior recession levels. They have moved higher, from some extremely low levels.
- Coincidence. Are the factors really related? The so-called Leading Economic Indicators come to mind. Our own analysis finds little relationship between these indicators and payroll employment growth. Other items, like the inverted yield curve, reflect unusual circumstances in the demand for US Treasuries, the "conundrum."
- Differentiating element in other time periods. This one is obvious. Many of the recession forecasts reach deep into history. Do we really think that markets and economic management from the Taft administration or the Great Depression are similar to current conditions? What about corporate improvements in inventory control? Is it possible that using computers makes a difference?
- Compare interest rates, inflation, dividend yield, P/E contraction or expansion, sentiment, overall market trend, business cycles -- across different eras. Might that account for potentially different outcomes? Yes! Circumstances in the early 70's, with very high interest rates, were different from now. Another example: The Fed interest rate actions in the bubble era were much slower than they are now.
- Consider things in terms of probabilities, not outcomes. Excellent! We wonder how anyone can state with 100% certainty that we are "now in a recession." Or the opposite. If a recession occurs, something that no one knows yet, the actual dating of the beginning by the NBER will be the prior peak. It might include the current period. If there is a bounce in the economy, it will not. Many of those so certain about a recession have been (mis-)predicting the economy for years. There is no statute of limitations. The media points out that these people saw the problem early, as if it were praiseworthy to miss major market gains.
These two excellent articles are good resources. Any time one sees a simple historical analogy, it would be wise to check out Barry's list of questions.