Wednesday, November 2, 2011

In the Recession Camp

In our blog posts we often mention the ISM Manufacturing Report on Business PMI and the ECRI Weekly Leading Index, which are usually at the front line of the many barometers of economic activity we watch regularly. While the ISM PMI is built so that a reading below 50 signals economic contraction, its historical track record in calling recessions is far from perfect. On the other hand, while the ECRI team has a stellar historical track record in calling recessions, their weekly growth index doesn’t feature an absolute threshold below which a recession signal is triggered, and its interpretation is not as straightforward, at least for outsiders.

John P. Hussman, a Ph.D. in economics and one of our favorite reads, recently suggested a way of combining these two indicators to obtain a single recession signal that is more reliable than the sum of its parts. Following his idea (but doing our own math, as always), we found that over the last 44 years, whenever the ISM PMI was below 54 and simultaneously the ECRI Weekly Leading Index Growth was below -5, the U.S. was already in a recession (as defined by the National Bureau of Economic Research) 86.80% of the time. Moreover, if the U.S. was not already in a recession, there was a 92.59% chance of entering one within three months and a 95.06% chance of doing so within six months. The accuracy of this combination is easily explained: Our research indicates that the ECRI Index leads the ISM PMI by about four months (see chart below). Therefore this set of conditions can be interpreted as economic growth being near stall speed (low ISM PMI) and headed lower (negative ECRI Index). Adding a third condition (negative S&P 500 trailing-six-month return) and lowering the thresholds to 52 for the ISM PMI and to -7 for the ECRI Index worked even better; whenever these three conditions occurred simultaneously, the U.S. was already in a recession 94.19% of the time and was going to be in a recession within the following three months 100% of the time. That means always. Incidentally, this latter combination is the one we observe today (ISM PMI 50.8, ECRI Index -10, S&P 500 trailing six-month return -10.66% as of 10/31/2011).

Just another (heavy) piece to add to the weight of the evidence.