Written by Gary
Weekend Market Commentary: There Is Talk Of A Coming Recession
UPDATED: 0900 EST 2014-09-27
Market crashes, bubbles and recessions are all the rage right now and just about every pundit in the financial news circuit, including myself, has made a prediction, commentary or some other exploit concerning these 'dire' topics. The one thing they all may have in common is that they seem to occur with a recession. The good news is that a recession is not imminent in spite of what some respected and knowledgeable economists say.
However, wouldn't it be nice if we could predict a recession? It may actually be possible with certain leading indicators. Let's take a look how this scientific prognostication may be done.
First, we have market 'corrections' from time to time and may be seeing one right now, but a recession is much more illusive and harder to predict and typically happen after a market correction.
Let's describe a recession and the more serious 'depression'. Pundits often describe a recession as a period of temporary economic decline during which trade and industrial activity are reduced.
Generally identified as two consecutive quarters of declines in quarterly real (inflation adjusted) gross domestic product (GDP).
Such periods, if they are mild, are called recessions and generally lasts from six to 18 months. But they are referred to as depressions if they are more severe like the Great Depression of 1929. The Great Depression started in 1929 and lasted at least through the 1930's and into the early 1940's (and that is the short story).
A good example of a recession is the most recent one we went through in 2008/2009. It started with four consecutive quarters of negative GDP growth in the last two quarters of 2008 and the the first two quarters of 2009. It is also known as 'The Great Recession' and many claim we have never recovered from it in-spite the US Government claiming it ended in June, 2009.
Wikipedia explains, '[Recessions] may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.'
A recession has many attributes that can occur simultaneously and includes declines in component measures of economic activity (GDP) such as consumption, investment, government spending, and net export activity. These summary measures reflect underlying drivers such as employment levels and skills, household savings rates, corporate investment decisions, interest rates, demographics, and government policies.
Economist Richard C. Koo wrote that under ideal conditions, a country's economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero. When these relationships become imbalanced, recession can develop within the country or create pressure for recession in another country. Policy responses are often designed to drive the economy back towards this ideal state of balance.
A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different. As an informal shorthand, economists sometimes refer to different recession shapes, such as V-shaped, U-shaped, L-shaped and W-shaped recessions.
Now we have an idea of what triggers a recession, but can we foresee one coming just by looking at current data? Just because we have a 'correction', doesn't mean we are entering a recession. Morgan Stanley thinks we can predict a recession with a new 'Risk Model' that can see a month in advance.
Morgan Stanley offers a new recession risk model that might be able to predict a recession a month ahead of time.
This model is based off of several key economic indicators such as hours worked, new hires, consumer confidence, etc.
Within this article we take a brief look at this new model and also take a quick summary look at a few of the indicators.
Wouldn't it be nice to know a month ahead that a recession was imminent? In a recent Wealth Management newsletter from Morgan Stanley a back-tested model shows the ability to predict a recession a month ahead of time. Naturally the usual disclaimer applies as past performance is no indicator of future performance.
Personally, I do not think a month advance warning is anything to brag about, because by then, your portfolio has already taken a severe beating. Although the next recession is a long way of, Hale Stewart, believes there will be a continual deceleration [of the economy] in the remaining part of this year and probably an uptick at the beginning of 2015. In writing what he believes that could 'reasonably' change the present dynamic for worse in the near future is interesting and apples to our discussion here as perhaps a precursor to a recession.
If the Fed actually starts raising short term rates while long term rates are declining, that would create one of the classic signs of a recession coming - i.e., a flat to inverted yield curve. If it happens in a deflationary environment, that would be even worse. Such a yield curve has only happened twice in the last 90 years -- in 1928 and 2006. That's why I call it the "Death Star."
The Federal Reserve Bank of Kansas City Working Paper No. 13-05 have produced a VERY complicated pdf entitled, Predicting Recessions with Leading Indicators: Model Averaging and Selection Over the Business Cycle. I read part of it and fell asleep. My opinion is that the Fed has not got it right in the past, nor will they get it right in the future - don't waste you time reading it.
Whenever you read a preface like this, run as fast as you can. It may cause eyes to burn, lose focus and hair to fall out. Memorizing it will impress your friends, but you still won't be able to predict a recession
This study proposes a data-based algorithm to select a subset of indicators from a large data set with a focus on forecasting recessions.
The algorithm selects leading indicators of recessions based on the forecast encompassing principle and combines the forecasts. An application to U.S. data shows that forecasts obtained from the algorithm are consistently among the best in a large comparative forecasting exercise at various forecasting horizons.
In addition, the selected indicators are reasonable and consistent with the standard leading indicators followed by many observers of business cycles.
Just joking, of course, but there is another more casual way to explain the difference between a recession and a depression When your neighbor loses their job, it's a recession. When you lose your job, that's a depression!'
Tomorrow in Part II, we will continue why Predicting The Next Recession may be possible with other simpler, but meaningful indicators that have a PERFECT track record in predicting recessions.
What are your thoughts? I would love to hear from you.
"The stock market has recovered so sharply for so long, you have to assume somewhere along the line we will get a significant correction. Where that is, I do not know." - Alan Greenspan, July 30, 2014
The markets are still susceptible to climbing on 'Bernankellen' vapor, use caution!
"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation inequities, they should try to be fearful when others are greedy and greedy only when others are fearful." - Warren Buffett
If you would like to get advanced buy/sell tweets, sign-up in the column to the right of this post by clicking on the 'Follow' button. Write me with suggestions and I promise not to bite.
To contact me with questions, comments or constructive criticism is always encouraged and appreciated:
Written by Gary