Mixed Signals - Crystal Ball Analytics

I was recently asked to comment on outlook of US financial markets, particulary on the prospect of the US economy slipping into a recession. As you would expect, to provide views on the big picture was tough for someone who spends his time nose deep in the sand hunting for undervalued companies. Nevertheless, the task was undertaken with gusto and I shall attempt to share the mis-mash of findings which I unearthed in my search for a crystal ball economic leading indicator.

Inverted Yield curve
Historically, the slope of the yield curve for US Treasuries has proven to be a reliable indicator for forecasting recessions, with a lead time of up to 6 months. In fact, the New York Fed has performed several studies investigating the reliability of this indicator. While examining historical spreads, I reached the following hypothesis. Specifically, the signals provided by the spread between the 10 year T yields and the 3 month Fed funds rate have been un-canningly accurate when: (a) the yield curve inverts more than 50 basis points and (b) for more than four quarters. When the foregoing two conditions are fulfilled, the US has, historically, experienced a recession. This is validated by data going back to 1965. As things stand currently, the US economic outlook certainly looks bleak, at least from the perspective of this indicator. So, it's likelihood of recession 1, no recession 0.

Dealer Doldrums indicator
Coincidentally, I chanced upon another leading indicator which attempts to make the call using the change in sales by new car dealers. It was unveiled by a New York Times columnist recently. According to the columnist, there is a correlation between the year on year change in sales by new car dealers on a trailing 12 month basis (adjusted for inflation) and a recession in the US. The correlation is positive when the sales figure is a negative 2% or greater. In more exact terms, if the figure is down 2% or more, a recession is either underway or set to begin within a few months. With data going back to 1968, this indicator has not warned of a recession which did not occur. According to data released by the Census Bureau, the sales figure has dropped to a negative 2.4%; so this dealer doldrums indicator suggests that a recession is either already under-way or will soon being. Its recession 2, no recession 0.

But before you reach for the mobile to call your broker to recession proof your portfolio, please read on.

Anxious Index
The Federal Bank of Philadelphia maintains the Anxious Index. This index refers to the probability of a decline in real GDP, as reported in the Survey of Professional Forecasters. In this survey, panelists are asked to estimate the probability that real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. Thus, the Anxious Index is the probability of a decline in real GDP in the quarter after a survey is taken. This Index tends to peak during recessions, then declines when a recovery seems near. For example, the Index fell to 14% in 2Q02 when economic indicators were turning brighter. Using data dating back to 1968, a recession always followed when the Index shot above 30%. In 3Q06, the Index painted a benign picture with the probability levels hovering at 10%, no where near the recession trigger of 30%. Now, the scoreboard reads - recession 2, no recession 1.

National Activity Index
Singing a similar tune is the National Activity Index maintained by the Chicago Fed (CFNAI). The monthly CFNAI is a weighted average of 85 indicators of national economic activity. The 85 economic indicators that are included in the CFNAI are drawn from four broad categories of data: (a) production and income, (b) employment, (c) personal consumption and housing, (d) sales, orders and inventories.

As month to month data in the CFNAI can be volatile, a three month moving average version is also published. This CFNAI-MA3 provides a more consistent picture of US economic growth. When the CFNAI-MA3 is below -0.70 after a period of economic expansion, there is increasing likelihood that a recession has begun. The CFNAI-MA3 reading for August stands at 0.2 - dispelling the worry hawks.

The next CFNAI will be released on the 21st of September at 10am Eastern Time. Visit the Chicago Fed's site if you are keen to track this. In the meantime, its recession 2, no recession 2.

Some one which I cannot quite recall once remarked - put two economists in a room and you will get four opinions. Does the opposing results confirm the foregoing? I am not sure but I know I should be better off sticking to burying my nose in the sand.