What Exactly Are You Trading When You Trade the 'Recession Contract'?

by: Barry Ritholtz

US Recession 2008

Chart via Intrade

I am only a partial believer in The Wisdom of Crowds.

Why? Most of the time, the crowd is correct. However, at turning points, or in manias, the crowd can be totally and expensively wrong. That's why I always watch the trend, and what the crowd is doing, and whether we are in one of those rare moments when the profitable thing to do is fade popular opinion.

Hence, it caught my attention in the Spring when the Intrade Recession forecast for 2008 suddenly went into freefall. The Economist community dropped the odds of recession dramatically over the same March to June period. Was the population of betters suddenly like minded?

This was one of those things I have been meaning to address. I nearly forgot about it, too, until suddenly a spate of articles and television pundits began relying on the above Intrade chart as evidence there will not be an economic contraction.

Off I go to the Intrade site to see what there was to see. It didn't take very long to discover the flaw in their betting process. According to Rules and Legal Info at the site, this bet actually is defined as: 

"For expiry purposes, a recession is defined as two successive quarters of negative real GDP growth.

Expiry will be based solely on the data reported by the U.S. Department of Commerce (Bureau of Economic Analysis, Table 1.1.1, "Percent Change From Preceding Period in Real Gross Domestic Product") as reported by the BEA.

If the table as reported at that time indicates that any two consecutive quarters between (and including) Q4 of the previous year and Q4 of the year specified in the contract are negative, then the contract will expire at 100. Otherwise, the contract will expire at 0. For example, if Q4 of 2007 and Q1 of 2008 both experience negative growth then the contract for 2008 will expire at 100."   

Aha! This bet is misnamed -- it is not a trade based upon whether the US is in a Recession; rather, it is a bet as to whether the US has 2 consecutive quarters of negative GDP. As we have so painstakingly discussed, that is not the definition of a recession.

Intrade recognized that GDP numbers tend to get revised long after the fact. So thety added yet another twist to this strange bet: 

"The final figures will be used for expiry - not the advance or preliminary numbers...Any changes to the result after the contract has expired will not be taken into account - Exchange Rule 1.4. 

So it is the Final GDP numbers, reported on the 3rd month after the quarter has ended, that will be the basis of determining the winner, and not the more accurate revised data, such as we just had for Q4 2007.

Astonishing. What a strange wager: It does not use the actual definition of recession, and it does not use the most accurate data available.

Regardless of the title, this is not a recession bet. Perhaps the trade "USA two Consecutive Quarters of Negative Final (but Unrevised) GDP" has less of a ring to it than USA Recession 2008.

Continual Spot Price, US RecessionPrice for US Economy in Recession (*see contract rules for definition*) at intrade.com


Portfolio's Felix Salmon points out that Don Fishback made a similar observation -- Don observes that according to Intrade's bet, there was no recession in 2001 !