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The Economic Trend Usually Looks Positive When Recessions Start

James Picerno profile picture
James Picerno

Recognizing when a recession starts in real time is, for all practical purposes, impossible. The one exception to that rule is if you're willing to endure a high number of false signals in your model. In that case, you'll see lots of new recessions starting, but only a handful will be the genuine article. But if reliability with a low error rate is required - as it should be - the usual routine won't suffice. Instead, you'll need a methodology that focuses on a broad set of key indicators. No less critical is how you define the analysis of the dataset. An optimal set of indicators won't mean much if you're running the analysis with a shaky modeling framework.

Consider the so-called Big Four Indicators - payrolls, personal income, industrial production, and consumer spending. This quartet has been identified by some analysts as the foundation of the US economy. If you had to choose just four indicators, the Big Four set is arguably at the top of the list. There's no reason why you should limit analysis to just four datasets - in fact, there's a compelling case to go deeper and wider. But given the popularity of using the Big Four as a rough proxy of economic activity, it's important to point out that it's easy to develop a false sense of security by looking at levels rather than rates of change - year-over-year change in particular.

The danger is that looking for recession risk in real time via levels rather than rates of changes is destined for failure. Why? Two reasons. First, it's hard to model trend changes with levels, which move too slowly to reveal timely warnings. This is an even bigger challenge when you consider that reliable recession-risk warnings will arrive after a new downturn has started.

This article was written by

James Picerno profile picture
James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers. Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg Markets, Mutual Funds, Modern Maturity, Investment Advisor, Reuters, and his popular finance blog, The CapitalSpectator. Visit: The Capital Spectator (www.capitalspectator.com)

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Comments (14)

RAP77 profile picture
I'm not sure. I have some stocks but am holding probably too much cash, waiting for the next big selloff which may or may not happen. I don't think the big run up since the election had much to do with Trump. Seems to me, markets were in consolidation mode for a couple of years and businesses were dong better than many expected.

Reducing environmental regulations won't help the economy much. They only shift costs from polluters to taxpayers and individuals whose health is impacted. I don't think Trump's tax reduction plan will be as much of a stimulus as many think. Many corporations pay little or no taxes after deductions. If smaller businesses could benefit from whatever gets done, that would be good. It may be hard for him to pass any tax bill unless spending cuts are enacted to offset the tax cuts. You know who those spending cuts will hit.
RAP77 profile picture
It was pretty obvious what was happening by March 2008 which gave investors plenty of time to prepare for what happened in Sept 08. Depending on where a person lived, a housing crash was obviously in the cards. I was writing for a small newspaper in North East LA County, the heart of the housing "boom" and in 2005 wrote an article on the change in home loans that occurred in 2004. Up to that point only a small percentage of loans were what came to be called "subprime." By 05, more than 40% of loans qualified for that description. It was an obvious bubble.
Curious Wanderer profile picture
RAP77, very true. What do you think of economic conditions now?
EK1949 profile picture
Great article, you can't predict recessions, no advance warnings and all that aside, here's how to predict a recession. It's kindling, kerosene, vanilla extract etc. No one cares now about the kindling and kerosene of the recession of 2012, 2013, 2014, 2015, 2016, 2017.......but people did care then, articles were written then, some of them even saying no one can predict recessions and here's mine! This author did not say that, which which I'm grateful.

" The Fed could've decided to lower interest rates, or leave them the same, instead of raising them and causing a recession, the way it happened in 2007."

Given how the Fed fights inflation no, it could not have done that. Further, I see no reason why "behind closed doors" made a difference. You know what goes in the box, you know what came out, it could have been a Taylor Rule or a vote, but rising inflation and the market itself is sending the signals.
RidgeHaven Capital profile picture
By the way, IWM just broke the 50 DMA along with the QQQ. SPY is next.
Curious Wanderer profile picture
On my charts, the SPX already breached the 50 DMA to downside today, the R2000 is right on it and the Nasdaq, as you say, breached it on 6/29 already. DJIA still above it. A little early to short the market for my taste. They could all bounce along the 50 DMA from here or even pull above it again, as they've done a few times in the past few months with all this liquidity from the ECB etc keeping this whole market up in lala land valuations.

I'm totally on board with you that the bonfire wood is all laid, the kindling is there, heck the kerosene is even poured on it, just don't think the match is struck yet that will truly start the bear. I have some PSQ inverse of the QQQ which I pair with some carefully picked biotechs so the pairing combo goes up more than market on up days and drops a bit less on downers like today. That's about all the shorting I have the stomach for at the moment 'cos it still looks like a bull market to me, though a very old one that I wouldn't sell a life insurance policy to!

On data I'm watching, I think we'll drop into recession sometime Q2-4 of 2018 and with the average bear starting about 7 months prior to recession, I just feel I'd lose a bundle of money shorting indices now. They're still likely to have upward momentum for at minimum 1 more quarter IMO.

Hey man, thanks for the reply - intelligent conversation on here is very welcome.
Curious Wanderer profile picture
Today the SP500 and Russell 2000 are both back above their 50DMA. DJIA stayed above it. Only the Nasdaq is below it and closing back up to it. SP500 is only 1.47% below its all time high; Nasdaq is 3.06% below. I still think it's too early for this to be a real market breakdown.
Curious Wanderer profile picture
DS, I hope you revised that short strategy. As discussed, this is too early. Market wasn't breaking down yet. A week later we are now at: S&P500 and DJIA at record highs. Nasdaq at second highest closing ever and R2000 only 0.02% below its record high. Basically, they all hit the 50 DMA and bounced up again. We're not at the end of this overvalued madness yet.
RidgeHaven Capital profile picture
You hooked me with the title. I went short this year when the U-6 rate hit previous lows. I took out a loan to buy stocks when people around me were selling their 401ks in 2009. Market cap to GDP is at historic highs now....
Curious Wanderer profile picture
You were short in H1 this year? What kind of result did that strategy deliver?
RidgeHaven Capital profile picture
You got me. I just went short a few weeks ago.

A recession is a change in human behavior. Which is always hard to predict, not just in economics but in everything else too.

Most US recession were caused by rising interest rates for people and organizations, who borrowed a lot of money and needed to roll over their debts once in a while, instead of repaying them.

And these interest rates didn't rise on their own. The US Fed decided to raise those interest rates for banks, which led to banks raising their interest rates for everybody else.

It was a deliberate human decision, rather than something happening naturally or by chance. And that's why it was so difficult to predict. The Fed could've decided to lower interest rates, or leave them the same, instead of raising them and causing a recession, the way it happened in 2007.

Perhaps a recession would happen on its own, if there was no Fed and no government to manage the economy. And that kind of a recession might be more predictable.

But in a managed economy, where a group of people gather behind closed doors and make an important economic decision in secret, then what they will decide can be very hard to predict.
Curious Wanderer profile picture
Thanks for the article. Helpful analysis. What does the rate of change graph for those Big 4 look like at present?
That is a good question, I second the motion.
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