Monday, August 22, 2011

Are we there yet? Are we there?

John Hussman posts his list of warning signs of a recession:

#1: Widening credit spreads: An increase over the past six months in either the spread between commercial paper and three-month Treasury yields, or between the Dow Corporate Bond Index yield and ten-year Treasury yield.

#2: Falling stock prices: S&P 500 below its level of six months earlier.

#3: Weak ISM PMI: Manufacturing PMI below 50.

#3a (alternate to condition #3): Weak PMI, and weak employment growth: Manufacturing PMI below 54, together with either
i) nonfarm payrolls below 1.3% the level of the preceding year, or
ii) an unemployment rate 0.4 percentage points (or more) above its 12-month low.

#4: Moderate or flat yield spread: Yield spread (ten-year minus three-month) below 2.5%, if condition #3 is in effect, or yield spread below 3.1% if condition #3a is in effect.

According to Hussman,Link
"the components of our recession warning composite might be called "weak learners" in that none of them, individually, has a particularly notable record in anticipating recessions. The full syndrome of conditions, however, captures a critical "signature" of recessions. That signature of "early warning" conditions is based on financial market indicators including credit spreads, equity prices and yield curve behavior, coupled with slowing in measures of employment and business activity. Every historical instance of this full syndrome has been associated with an ongoing or immediately impending recession."

I was intrigued by this list of "warning signs," so I put them to a test. Would these variables have predicted a recession in the summer of 2010, when the U.S. economy was on the brink of a recession-cum-deflation, but a recession did not actually ensue? The following table details whether each of the four "Hussman signs" are in effect now and last summer:

Summer 2010
Summer 2011
#1Yes. The credit spread (measured by the Moody's seasoned BAA yield minus the 10-year Treasury yield) was above its level six months prior between June 2010 and December 2010. The credit spread reached its maximum in November 2010.
Yes. The credit spread has been higher than its level six months prior since 6/24/2010. The spread is still rising.
Yes. The six-month price change turned negative in late May 2010. It was persistently negative from 8/20/2010 through 10/29/2010. The minimum that summer was in late August.
Yes. The six-month price change turned negative in early August and is still negative.
Nope, not even close. The minimum that summer was 55.10, reached in July.No (but almost). The PMI reached a new low of 50.9, just a hair away from 50, which indicates a contraction of manufacturing activity. The PMI has been declining every month since February 2011.
Yes. This condition was fulfilled in May, when the PMI dipped below 54, and again in July. Annual payroll growth has been below 1.3% since March 2007. Over the 12 months to July 2011, the most recent month with available data, payroll growth was 0.97%.
No. Since neither condition #3 nor #3a were in effect, condition #4 was not in effect either. In any case, the spread reached a low of 2.3% in October.
Yes. The spread has been below 3.1% since May, and is now below 2.5% (and falling).

This summer, it appears, it is much more likely that a recession occurs within the next few months that it was last summer. In fact, all four of Hussman's warning signs are in effect.

What do other leading indicators say? I take a look at three widely-followed leading indices of economic activity:

Summer 2010
Summer 2011
ECRI WLI leading index
The growth index turned negative in early June 2010. It had been declining since October 2009. In the summer of 2010 the WLI reached a low of -10.9, in July. In the 40+ year history of this index, the economy had never avoided a recession when the index reached such a low value.
The growth index turned negative on the week ending in August 12, with a value of -0.1. It has been declining since April 2011.
Conference Board's leading economic index
The LEI fell slightly between May and June of 2010. The growth rate slowed down significantly as the summer proceeded.
The LEI has not ceased to increase at all. The growth rate has not slowed down, as of July 2011.
Philadelphia Fed's leading index
The index declined persistently from May 2010 through September 2010, although it did not turn negative.
The index has declined persistently since April 2011.

All signs point to a continuing slowdown of economic activity, not to rebound. The odds of a recession are high, are arguably higher than last summer. The discordant indicator is the Conference Board's leading economic index, which is not showing signs of a slowdown.

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