The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through January 2013.
If you are new to Trader Edge and would like some additional background on the development of the Trader Edge recession models, I encourage you to read the previous recession model update, which also has links to earlier articles.
The Trader Edge diffusion index equals the percentage of independent variables indicating a recession. There are a total of 16 explanatory variables, each with a unique look-back period and recession threshold. The resulting diffusion index and changes in the diffusion index are used to estimate the probit, logit, and neural network forecasting models.
The graph of the diffusion index from 1/1/2003 to 2/1/2013 is presented in Figure 1 below (in red – left axis). If you would like to view a graph of the earlier historical data (going back to 1960), please revisit A New Recession Slack Indicator. The gray shaded regions in Figure 1 below represent U.S. recessions as defined (after the fact) by the National Bureau of Economic Research (NBER). The value of the S&P 500 index is also included (in blue – right axis).
The diffusion index was unchanged in January, remaining at 6.3%. In other words, the percentage of explanatory variables indicating a recession was stable at 6.3%. Only one out of the 16 explanatory variables is currently indicating a recessionary environment.
Please note that past estimates and index values will change whenever the historical data is revised. All current and past forecasts and index calculations are based on the latest revised data.
Recession Slack Index
The Trader Edge recession slack index equals the median standardized deviation of the current value of the explanatory variables from their respective recession thresholds. The resulting value signifies the amount of slack or cushion relative to the recession threshold, expressed in terms of the number of standard deviations.
The latest recession slack index value was 1.01 standard deviations above the recession threshold, down slightly from a revised value of 1.06 last month.
The gray shaded regions in Figure 2 below again represent U.S. recessions as defined by the NBER. The median recession slack index is depicted in purple and is plotted against the right axis, which is expressed as the number of standard deviations above the recession threshold.
The dark-red, horizontal line at 0.50 standard deviations denotes a possible warning threshold for the recession slack index. Many of the past recessions began when the recession slack index crossed below 0.50. Similarly, many of the past recessions ended when the recession slack index crossed above 0.0.
While it is useful to track the actual recession slack index values directly, the values are also used to generate the more intuitive probit and logit probability forecasts.
Aggregate Recession Probability Estimate
The Trader Edge aggregate recession model is the average of four models: the probit and logit models based on the diffusion index and the probit and logit models based on the recession slack index. The aggregate recession model estimates from 1/1/2003 to 2/1/2013 are depicted in Figure 3 below (red line – left vertical axis). The gray shaded regions represent NBER recessions and the blue line reflects the value of the S&P 500 index (right vertical axis). I suggest using a warning threshold of between 30-40% for the aggregate recession model (green horizontal line).
The aggregate recession model probability estimate for 2/1/2013 was 0.1%, which was unchanged from last month.
Aggregate Peak-Trough Probability Estimate
The peak-trough model forecasts are different from the recession model. The peak-trough models estimate the probability of the S&P 500 being between the peak and trough associated with an NBER recession. The S&P 500 typically peaks before recessions begin and bottoms out before recessions end. As a result, it is far more difficult for the peak-trough model to fit this data and the model forecasts have larger errors than the recession model.
The Trader Edge aggregate peak-trough model equals the weighted-average of nine different models: the probit and logit models based on the diffusion index, the probit and logit models based on the recession slack index, and five neural network models.
The aggregate peak-trough model estimates from 1/1/2003 to 2/1/2013 are depicted in Figure 4 below, which uses the same format as Figure 3, except that the shaded regions represent the periods between the peaks and troughs associated with NBER recessions. The aggregate peak-trough model probability estimate for 2/1/2013 was 5.7%, which was up slightly from the revised value of 4.1% at the end of December.
U.S. recession risk remained very low in January, which is ironic following the reported -0.1% GDP growth rate for Q4 2012. The recession slack index was still comfortably above its 0.50 warning threshold and the aggregate model forecasts and diffusion index values were still well below their 30%-40% warning levels.
While the negative GDP value was a surprise, trends in the entire spectrum of economic and market-related explanatory variables are inconsistent with past recessionary environments.
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