As longtime readers know, one of our favorite fund managers is John Hussman of Hussman Funds. His scientific approach to market analysis is similar to our own and he recognizes that forecasting is a matter of identifying the likely scenarios along with their associated probabilities. In his latest weekly commentary, Hussman reviewed the recession scenario, noting that a return to economic contraction remains highly likely according to the most reliable historical indicators that he monitors.
We use a variety of methods to gauge recession risk. The most straightforward is to form fairly low-order indicator sets like our Recession Warning Composite (see November 12, 2007, Expecting A Recession ), that have a long historical record of accurately distinguishing recessions. These indicator sets are comprised of what might be called “weak learners” – conditions that do not in themselves have infallible records of identifying recessions, but that provide very strong signals when observed in combination with other recession flags. They include fairly straightforward conditions such as whether or not the S&P 500 is below its level of 6 months earlier, whether credit spreads are wider than they were 6 months earlier, whether the Purchasing Manager’s Index is in the low 50′s or below, and so forth.
As of last week, a simple average of 20 of these binary recession indicators continued to show a preponderance of signals still in place – a condition that has never been observed except alongside a U.S. recession.
Moreover, we can select random subsets of these indicators across random periods of time, in order to make the model less sensitive to exactly how it is put together. That method typically produces more variation in the overall conclusion about the economy, so the confidence in that conclusion is particularly strong when multiple models agree. At present, we observe agreement across a broad ensemble of models, even restricting data to indicators available since 1950 (broader data since 1970 imply virtual certainty of recession). The uniformity of recessionary evidence we observe today has never been seen except during or just prior to other historical recessions.
We also continue to forecast a highly likely return to economic contraction in the US sometime during the next two quarters. Our computer model indicates that the recession scenario currently has a probability of greater than 80%, aligning closely with the outlook provided by Hussman. Admittedly, it can be difficult to maintain a particular long-term outlook as the market experiences violent short-term sentiment swings, which is why it is so important to use a time-tested forecasting methodology that has a long history of reliability. We often wonder why so many mainstream analysts continue to rely upon projected corporate earnings to predict future market returns, as this “forecasting” method has a long, notorious history of consistently producing inaccurate projections, especially near secular and cyclical inflection points. Still, projected earnings remain a forecasting mainstay on Wall Street, providing another excellent example of the famous Mark Twain adage: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”