Being Early and Being Wrong
On the subject of recessions...
When making a call that has certain investment implications, getting the timing right is just as important as the overall trend. Quite often, investors view the world as half full or half empty, bullish or bearish, and seek out the data points that confirm some larger pattern. Consequently, when a public prediction or call has been made, putting one’s reputation on the line, it is not uncommon for even highly respected money managers or analysts to ignore all data to the contrary of their thesis until being forced to either revise their views or claim that, like a broken clock, they'll eventually be proven correct.
In lieu of the above, the surest way for long-term investment success is to continually strip one’s own bias out of the equation and take a weight-of-the-evidence approach to see what the true lay of the land is. While some like David Rosenberg, as noted by Business Insider, will pick on a particular data set like CAPEX (article link) or, for example, the Economic Cycle Research Institute (ECRI), which points to a peak in coincident data (article link) to support their views, there are plenty of other figures that show there is no imminent threat of a recession. More importantly, the final arbiter of determining if one is right or wrong, the market, shows no imminent threat either.
Two Legs are Better Than One
My criticism of those who essentially say, “this is the chart", to support their recession calls comes from realizing that relying on one data set is foolish as there are no black boxes or a single indicator that has always been right without any false signals. Relying on only one leg to stand on puts us on shaky ground rather than having both—preferably numerous—feet firmly below you. I suffered from this same mistake last year when I was calling for a recession based on the Philadelphia Fed’s State Coincident Diffusion Index (Economic Indicators Show Recession As Early As Next Month). I highlighted that dips below 50 often came a few months prior to a recession’s onset and that we were likely to slip in to a recession in late Q3 to Q4 of 2011. As you can see below, we dipped below 50 last year and this year without an ensuing recession.
As was the case then as it is now, there are plenty of other indicators that are not supporting a recession call, which I'll show below, so rather than trying to time things early and suffer the unfortunate event of being wrong, it is far more prudent to observe widespread confirmation, especially with global central banks proactively steering the markets.
The first indicator I'd like to point out as unreliable in signalling recessions is one that has been trotted out on numerous occasions recently: the Chicago Fed National Activity Index (CFNAI). However, as you can see below, the CFNAI has fallen to current levels near the recessionary threshold (-0.70) before pulling a 180 degree turn. Thus, although the CFNAI is certainly weak, we need to see a definitive break before raising the red flag.
On the other side of things, take a look at the Conference Board’s Coincident Diffusion Index below. At a smoothed reading of 90% we are nowhere close to being in recessionary territory (sub 60 readings).
Also, the year-over-year (YOY) rate of change in jobless claims is still declining and, as seen by the chart below, still far from the recessionary trigger of 15% annual growth.
Stop Talking and Start Listening!
The subtitle above was used for an article I penned back in February (link). I’d like to repeat a few comments that I think are relevant for those firmly in the bearish camp.
Basically, listen to the message of the markets and then interpret those messages rather than telling the markets what they should be doing. What the market IS doing is far more important than what you think the market SHOULD be doing. Right now the message of the stock markets, credit markets, and economy is this, “THERE IS NO NEAR-TERM RECESSION OR BEAR MARKET!”
The market is the final arbiter of whether one is right or wrong. Are you bullish on “XYZ” stock? We will know you are right if XYZ’s stock advances weeks and months out from your call. If “XYZ” falls by twenty percent or more over a few months, then clearly you are wrong as the bearish case for the stock overwhelmed the bullish case. Are you bearish on the economy or stock market? If so then stocks should sell off, credit spreads blow out, and economic data come unglued.
What is the current message of the market? As shown by the charts above and a few more to follow, the market appears to be telling investors to relax, that everything is just fine and we may in fact be seeing early signals that global growth will accelerate into 2013. Shown below is Bloomberg’s Financial Conditions Index (FCI) for both the U.S. (top panel) and Europe (bottom panel). The FCI for both Europe and the U.S. deteriorated beginning in 2007 and didn’t stop falling until late 2008, providing an early lead time for both the market’s top and bottom. We saw small unsustained dips in both during 2010 and 2011 but not the continued deterioration that we saw in 2007 that gave warning of a coming recession.
Looking at both today shows that they are near 5-year highs and showing no signs of credit stress here or across the pond. In fact, during the summer when European markets were selling off (black line, lower panel), the FCI for Europe merely paused on its ascent and the stock market eventually heeded the message of the credit markets and improved. Looking at the technical setup for European stocks shows a potentially bullish picture as European stocks appear to have put in a double bottom (“W”) and a breakout above near-term overhead resistance, which, to the surprise of many, could have bullish implications for European growth.
Other credit indicators are supporting the benign outlook provided by the Bloomberg Financial Conditions Indexes for the U.S. and Europe. For example, overnight lending rates among banks are resting near some of their lows and continue to improve.
Money market spreads also remain near 3-year lows. A sustained rise would spell caution and worry ahead. Currently this is not the case.
Other market messages are present in the junk bond and commodity markets. Heading into the 2007 bull market peak and prior recession we saw commodities tumble (red line, bottom panel) and credit default swaps (CDS) for high yield bonds (black line, bottom panel shown inverted for directional similarity) jump. Looking at both today shows industrial commodity prices that appear to be putting in a multi-year bottom and on the verge of breaking out and high yield CDS spreads that rest near 4-year lows. The market is clearly not worried about the U.S. fiscal cliff pushing the economy into a recession. While that may be the case now things can change quickly, which is why observing a wide range of key indicators and economic data is important in discerning either temporary or longer-term trends.
It is a foolish exercise to make a call based on one figure or chart when there is plenty of other data that contradicts one’s findings. Ultimately, those who fail to listen to the message of the market will find themselves often on the wrong side. Unfortunately, saying you are “early” only goes so far. When surveying the multitude of indicators that are out there (including those I haven't shown for time's sake), I would say that the U.S. economy is not in danger of slipping into a recession as of yet and the market is likely to find its footing once more when we remove the fiscal cliff uncertainty.