Tuesday, January 31, 2012

A composite of leading indices

Following up on yesterday's post, here's a chart of a composite of leading indices for the U.S.:

When the super-index is below zero, there is a high probability that the economy enters a recession within three to six months. The lowest value of the super-index with a false positive signal of recession since 1967 has been -3.3 (in 2002). As of November 2011, the super-index was at -5.7. November was the fourth month in a row with a negative value. All three components of the super-index were negative as of November.(By the way, I’m using the brand new, improved index from the Conference Board, not the old, useless one.)

The December’11 value for the OECD index is not available yet. The other two indices were higher in December than in November, indicating a weaker signal of recession than in November. However, in all likelihood the super-index will still be around -5.

Statistical models like this do not “guarantee” anything. It’s still possible that a recession doesn’t happen.

One of two things may be happening:
1) The model is correctly pointing to a recession.
2) The model is “breaking down”: it is not able to capture the leading business cycle dynamics at present.

In the absence of any arguments supporting #2, and in light of the broad evidence from domestic and international macro data, it is prudent to say that the risk of recession is high.

It is also prudent considering the large divergence of outcomes. If the model is wrong, and no recession occurs, the best we can hope for is a mediocre recovery. This is what the stock market seems to be pricing in at present. If the model is right, and we do have a recession, sales and earnings will fall way short of “consensus expectations,” macro data will surprise on the downside, and risk-aversion will kick in, in which case stock prices are likely to dip. This is definitely not priced in by the market at present.

Construction of the super-index:

1. Calculate the three-month moving average of each of the following indices: the Conference Board’s Leading Economic Indicator (LEI) index, the OECD composite of leading indicators, and the ECRI weekly leading index. (For the latter, I start with the monthly figure, which is itself a monthly average of the weekly values.)

2. Calculate the six-month % change, at an annual rate, of each of the moving averages from step 1.

3. Average the three % changes.