John Hussman asks us to consider the importance of leading versus lagging economic indicators:
Accompanying the news of the “grand and comprehensive” European solution on Thursday was the news that GDP rose at an annual rate of 2.5% in the third quarter.
There was already coincident data that the U.S. was not yet in contraction in August or September, so this was no surprise. Still, investors continued the habit of confusing lagging and coincident indicators for leading ones, so the positive GDP figure was taken as evidence that an oncoming economic downturn was “off the table.”
I can’t emphasise enough that leading evidence is in fact leading evidence. Take, for example, the ECRI Weekly Leading Index. It’s certainly not a perfect indicator in itself, but its leading properties are instructive. If you look at the historical points where the WLI growth rate fell below zero, you’ll find that weekly unemployment claims (a coincident indicator) were generally still about 3% below their 5-year average.
It generally took about 13-16 weeks for unemployment claims to climb above that 5-year average, and even longer for the unemployment rate (a lagging indicator) to rise sharply. That’s not much of a lag in the grand scheme of the full economic cycle, but allows a great deal of intervening and often contradictory action in the financial markets.
The tendency to demand predictable outcomes to also be immediate is a dangerous one, because it allows investors to be sucked in by temporary reprieves during what are, in fact, very negative conditions. As I noted in May (see Extreme Conditions and Typical Outcomes ), “It’s clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months.
Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several per cent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes.”
The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest very high recession risks, and even sparse combinations of indicators provide a major basis for concern.
For example, since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.
If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.
That simple set of conditions (WLI < -5, PMI < 52, SPX < 6 months earlier) has been seen in every postwar recession for which the data is available. Though we’ve seen recessions without a drop in the WLI much below -5, when a WLI below -7 has been coupled with a PMI below 52 and an S&P 500 below its level of 6 months earlier, the economy has been in recession within 13 weeks, 100% of the time. This is the combination, incidentally, that we observe today.
We certainly don’t base our economic expectations solely on these data points, as a broad ensemble of other data continues to present high risk of an oncoming recession. Still, we view the virtual abandonment of recession concerns to be remarkably naive, and lacking of any real basis in historical evidence.
Wall Street eagerly points to 2010, when the ECRI’s WLI dropped below -10 without a subsequent recession, largely thanks to the brief can-kick produced by QE2. But even in that instance, a smaller set of negatives was in place (the ECRI itself did not observe enough deterioration in its indicators to project a recession). In the present instance, a much broader range of evidence has turned down, both in the U.S. and internationally.
Given that nothing in economics is entirely certain, it’s possible that this time will be different. But that possibility is not one that has support in the data. To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time that similar data has been in hand.
We share the concern. While we are not convinced a recession is a definite outcome here, we too wonder at the ability of investors to continue to weigh current data ahead of forward looking indicators. In addition we are told repeatedly by many we will not have a recession unless a shock from Europe, China or elsewhere were to occur. Which brings to mind two points.
- If an overseas shock could lead to recession then our economy is in a very fragile state. Obviously the margin for error in such an analysis is quite small and thus could be quite incorrect.
- Shocks from China and/or Europe over the next six to twelve months are not exactly a remote possibility.
To wit, Hussman addresses some of the issues with Europe’s latest “solution” as well.