Recession Radar

For the latest Recession Radar reading, see the numerical graphic in the right margin of www.PFnewsletter.com. For an explanation of the methodology and value of Elliott Gue’s Recession Radar, please continue reading…  

The stock market is a proven leading indicator for the economy. Since 1929, the US economy has been through a total of 14 recessions and all but one of those downturns–a short contraction in 1945–was accompanied by a pullback of about 15 percent or more in the S&P 500. On average stocks have topped out about four months before the economy slipped into recession and bottomed five months before the economy hit its trough.

A good example of the stock market’s predictive powers is the Great Recession of 2007-09. The S&P 500 hit its highs in October 2007, two months the before the economy officially entered recession. The index then fell to multiyear lows in March 2009, about four months before the economy exited the downturn. 

There is no perfect economic indicator; economist Paul Samuelson once famously quipped that the stock market has forecast nine of the last five recessions. Since 1980 alone the S&P 500 has experienced severe corrections in 1984, 1987, 1998 and 2002 and none of these preceded economic contraction. Furthermore, although some pundits define a 20 percent decline for the S&P 500 as a “bear market” numerous US recessions since 1945 haven’t caused market declines of that magnitude. And once the S&P 500 has retreated by 20 percent, the economy is usually several months into a recession–hardly a successful leading indicator.

Nevertheless, a statistical technique known as logistical regression can transform stock market performance into a fairly reliable economic indicator. Armed with a half century of economic data, I’ve constructed an equation–known as a logit model–that estimates the probability of recession over a six-month forward-looking window–the results are displayed in my graph “Radar Tracker.”

Three recessions have struck the US economy since 1990, and my model of stock market performance has a solid track record of forecasting these downturns. The stock market indicator showed a greater-than 50 percent probability of recession in the early stages of the 1990 and 2007-09 recessions. It also predicted the 2001 downturn months ahead of time.

My stock market indicator hasn’t eliminated false alarms; in 1998 and 2002, the indicator incorrectly called recession. But when the predictions were correct, the signals came early enough to spare investors from the bulk of the stock market’s downturn.

But stock market performance isn’t the only leading indicator of economic performance. I also closely watch initial jobless claims–the number of people filing for first-time unemployment benefits. It’s well known that initial claims spike just before or in the early stages of an economic downturn.

I constructed a similar logit model based on jobless claims data stretching back to the 1960s, which are also displayed in “Radar Tracker.” As you can see, the Logit Model based on initial claims spiked above 50 percent in the early stages of all three recessions since 1990. Although this model called the 1990 and 2007-09 contractions later than the stock market model, it actually predicted the 2001 downturn months before stock market data.

Even better, initial claims never spiked enough to indicate recession in 1998 or 2002–an investor following this model might have correctly seen both as stellar buying opportunities.

The stock market and jobless claims are flawed indicators on their own. But together they provide a more accurate picture of the actual risk of recession. These are just two of the data sets I used to create the Personal Finance Recession Radar, which is updated with each issue of Personal Finance. This proprietary metric also tracks eight additional economic and financial indicators including data that covers credit and commodity markets, monetary conditions, manufacturing activity and confidence. The Personal Finance Recession Radar offers a quick and dispassionate gauge to the risk of an economic contraction over the ensuing six months.

No model or indicator is perfect. And investors should not rely solely on any single indicator when they make investment decisions. But the Personal Finance Recession Radar is another useful tool that can help us to identify rising recession risks early on and take appropriate steps to reduce risk.

 

For the latest Recession Radar reading, see the numerical graphic in the right margin of www.PFnewsletter.com.

For the latest Recession Radar reading, see the numerical graphic in the right margin of www.PFnewsletter.com. For an explanation of the methodology and value of Elliott Gue’s Recession Radar, please continue reading…  

The stock market is a proven leading indicator for the economy. Since 1929, the US economy has been through a total of 14 recessions and all but one of those downturns–a short contraction in 1945–was accompanied by a pullback of about 15 percent or more in the S&P 500. On average stocks have topped out about four months before the economy slipped into recession and bottomed five months before the economy hit its trough.

A good example of the stock market’s predictive powers is the Great Recession of 2007-09. The S&P 500 hit its highs in October 2007, two months the before the economy officially entered recession. The index then fell to multiyear lows in March 2009, about four months before the economy exited the downturn. 

There is no perfect economic indicator; economist Paul Samuelson once famously quipped that the stock market has forecast nine of the last five recessions. Since 1980 alone the S&P 500 has experienced severe corrections in 1984, 1987, 1998 and 2002 and none of these preceded economic contraction. Furthermore, although some pundits define a 20 percent decline for the S&P 500 as a “bear market” numerous US recessions since 1945 haven’t caused market declines of that magnitude. And once the S&P 500 has retreated by 20 percent, the economy is usually several months into a recession–hardly a successful leading indicator.

Nevertheless, a statistical technique known as logistical regression can transform stock market performance into a fairly reliable economic indicator. Armed with a half century of economic data, I’ve constructed an equation–known as a logit model–that estimates the probability of recession over a six-month forward-looking window–the results are displayed in my graph “Radar Tracker.”