by Jeff Miller
Since last May I have been reviewing the record of those who forecast the business cycle. I developed a stringent list of requirements, “Jeff’s Acid Test,” and I frequently invited nominations. Here were the stated requirements:
- Openness — with the potential for peer review
- Small number of input variables. Most people do not understand that “small is good.” If you have a lot of variables, it is easy to do back-fitting on a few cases. Beware.
- Real-time performance. This means that you do not go back in history doing any data-mining. You create an indicator and live with it through time.
I received a number of suggestions in the comments and by email. I very much appreciate the help from readers. One result is that I am monitoring a number of new and promising forecasting methods. I plan a later article on the honorable mention winners.
Somewhat to my surprise, there was only one candidate who met all three criteria:
Robert F. Dieli and Mr. Model
Most people think they know about recession forecasting, but they are often responding to someone’s last good call or who has the best PR team. The Dieli method hits a winning trifecta — it is based on sound intellectual premises, it has worked better than any other method in real time, and it is open for our review. What more can we ask?
This is Part 2 of a planned five-part series on recession forecasting (Part 1 is here). I know that many will want to dig into the nuts and bolts of the Dieli method, and I will start that in the next segment. There will be plenty of opportunity to for comparison and discussion of various methods.
For now, let us just think about the results in terms of the long-term track record, and learn a little more about how the model was developed.
Let’s start with a look at Mr. Model.
The key variable is the Aggregate Spread, depicted by the blue line. It depends upon monthly data, and will be updated next week. The trigger point is the 200 level. Whenever the blue line crosses 200, it is a forecast of a “cycle event.” The forecast horizon is pretty close to nine months. This means that when the line crosses 200 moving lower, it is a nine-month warning of a peak, AKA recession start as defined by the NBER. When the line crosses moving higher, it provides a nine-month warning of a trough.
Doug Short does an excellent job with the two most popular candidates in his update article, The Great Leading Indicator Smackdown. There are several excellent charts, and I recommend reading the entire article. For our current purposes, I am selecting the one that best matches the Mr. Model forecasts.
I invite the reader to scroll from left to right, looking at the lead times for both the onset and the end of recessions. (I understand that the ECRI uses both an acceleration term and other indicators to augment their calls, but we have to start somewhere.)
It would be nice to put all of these indicators on a single chart, but I think the strength of Mr. Model is apparent.
The Man behind the Model
As background for the record, I have known Bob Dieli only for a few months. Since we both reside in the Chicago suburbs, it was convenient for us to meet for lunch after a joint appearance on a panel. I appreciated his openness, honesty, and intellectual rigor. I was even more impressed by the results of his method. When I learned that he had not tinkered with it over the years, I really perked up.
This is a very unusual combination, helping to define someone as the “real deal.” Here is the interview I later conducted.
Q: Bob, tell us a little bit about how and when you first conceived the ideas behind Mr. Model?
The origins go all the way back to graduate school at the University of Texas in the 1970s, when I first became interested in the business cycle. I began to work on the model in its current form while I was doing economic research at the Continental Bank from 1978 to 1984 and at the Northern Trust from 1987 to 1994. Both were financial institutions with major exposure to the risks associated with business cycle peaks and troughs.
Q: You have had a number of high-profile jobs. Did your economic research on this topic continue through all of these experiences?
Over the course of my corporate career I spent time in staff assignments in economic research and later in line assignments in credit risk management at the Continental during the crisis that led to its implosion. In 1987 I became a fixed-income portfolio manager at the Northern, where my clients were mostly high net worth individuals.
Can you tell us a little more about how these positions helped you develop your skill as a forecaster?
The combination of those experiences gave me some important insight on the preparation and use of forecasts. I learned that details of great interest to the forecast originator may not be very important to the forecast user. The bottom line was that accurate and insightful forecasts, delivered in a timely and usable manner, were the most sought after by decision makers.
Q: You feature a chart of economic performance and model signals, with an excellent real-time record. Can you elaborate on that a bit?
My objective was to find a format that allowed the user to draw conclusions quickly. This turned out to be charts with long historical tails that provide perspective and context at a glance.
Q: You also write extensively on employment. This actually represents a second approach for your economic analysis, I think. Is it giving you a similar signal right now?
The employment figures are among the most informative statistics we have. They are the best coincident indicators of economic conditions and, as such, give you a great place to start on figuring out where we are in the business cycle and what is likely to happen next.
Q: How much lead time do you usually see between a signal from Mr. Model and an economic peak or trough?
The Aggregate Spread, which is the principal forecast statistic, operates with a constant nine month forward look. Unlike other leading indicators which operate with a variable lead time, the Aggregate Spreads looks ahead nine months at all times. Think of it in the same terms as the beam on the radar on your local weather channel. The historical record has shown that when the Aggregate Spread gets to 200 Basis Points, from either direction, we have reason to think there will be a cycle event (either a peak or a trough) some time in the time period nine months ahead of the arrival of the Aggregate Spread at the 200 Basis Point boundary.
Q: Making those calls out nine months must lead to some interesting conversations with your clients.
Indeed they do. For example, the signal for the peak of the 2001 recession that began in March of that year, came from model readings obtained in June of 2000. Telling folks, in the middle of the tech boom, that the business cycle had not been repealed and that we would have a recession the following year was a tough sell. Similarly, the indications that the recession of 2007 would end in the middle of 2009 began to emerge late in 2008 and in early 2009. Trying to tell folks that the economy would turn up while it was in the midst of what looked like a free fall in the first quarter of 2009 was even more difficult. But, because the model has the track record that it does, by the end of the first quarter of 2009 most of my readers were convinced that the worst of the recession was over and that a bottom would be forming.
Q: To make this clear, while you talk about markets, you are not making market predictions. You are predicting the economy, right?
That is correct. What I am out to do is anticipate the dates of business cycle turning points as determined by the National Bureau of Economic Research (NBER) with enough warning to allow effective planning. The stock market, the fixed-income market, and the housing market, to name just three, all have their own cycles. Sometimes those cycles match up closely with the NBER turning points, and other times they don’t. But you can’t know that until you know the NBER dates. The Aggregate Spread has an excellent record of showing, as much as a year ahead, when an NBER event is likely to take place. Armed with that information, and the specifics of their industry, or market, informed decision makers can make appropriate plans.
Q: Could you tell us a little be about your firm and its clients?
I’d be glad to. RDLB was started in 2002. My clients consist of three main groups: money managers, companies that make things, and individual investors. I send my monthly reports, which are available by subscription on my website, to all of these groups. I am available to all my subscribers for additional interpretation of the report contents. I also have a consulting practice in which I function as their economic research department. The assignments are as varied as the firms themselves, which makes the work very interesting to me. I also do public speaking before trade groups and gatherings arranged by and for my clients.
Q: Why do you call your site “Nospinforecast”?
Because the forecasts and viewpoints expressed there are completely data driven. I talk about what is on the charts. I don’t rant and I don’t take sides. I report the information and provide complete access to my forecasting methods. While I do talk about possible future outcomes, I do so within the context of numbers themselves. My objective is to provide my readers with information they can use to assess other views and forecasts as well as information they can use to effectively manage their business and financial affairs. One of the reasons I do this is because of lessons I learned while working with the trading desks at both the Continental and the Northern. The same piece of economic information might be reason for one desk, say short-term fixed income, to buy and another desk, say foreign exchange, to sell the instruments they traded.
Q: Thanks, Bob, for your helpful and informative comments.
Thank you for the chance to talk about Mr. Model.
Conclusion — Part 2
There is plenty more to discuss. I will get into the workings of Mr. Model in Part 3. We will revisit the comparison with the ECRI in part 4. These are tentatively on the agenda for next week.
Meanwhile, everyone should note that a “cycle event” — aka recession — is not expected for at least nine months. Unlike those who ascribe 0% or 100% chances of events, I understand that bad things can happen.
Nevertheless, you should keep this in mind:
In the 50-year history of Mr. Model, when the indicator is at current levels, there has NEVER been a recession within nine months. In fact, we are not even close to the nine-month signal.
Evaluating Recession Forecasts: Read Critically by Jeff Miller
Related Articles listed at end of above article.