Predicting recessions is notoriously difficult. However, there is at least one organization that has been successful in the past. The Economic Cycle Research Institute (ECRI) is one of the leaders in business cycle forecasting. According to The Economist magazine (in 2005),
“ECRI is perhaps the only organization to give advance warning of each of the past three recessions; just as impressive, it has never issued a false alarm.”
I have been very impressed with the ECRI and with Lakshman Achuthan, their Co-founder and Chief Operations Officer. Unfortunately, their services are tailored to institutional clients and their prices are difficult to justify for most retail investors.
In addition, they do not share their proprietary methodology, but they do publish their U.S. weekly leading index (WLIW). The complete weekly history for the WLIW index is available for download on the ECRI website (in an Excel spreadsheet). I import the index data every week into AmiBroker, my primary research platform.
ECRI made a controversial recession call in September of 2011 and they are sticking to their forecast, even with equity indices approaching all-time highs.
ECRI Weekly Leading Index Rising Rapidly
While a number of economic data series support ECRI's recession forecast (the JP Morgan Global PMI is an excellent example), the recent behavior of ECRI's own weekly leading index appears to contradict their own forecast. In fact, the WLIW has been rising rapidly for the past three months.
The top panel in Figure 1 below is a weekly (AmiBroker) candlestick chart of the S&P 500 index through October 5, 2012. The blue line is a six-week simple moving average, which can be used to help identify the trend.
The second panel is a weekly candlestick chart of the weekly ECRI leading index series. Obviously there are no high and low values, but I plotted it using candlesticks to make it easier to see the weekly changes. Again, the blue line represents a 6-week simple moving average of the ECRI weekly leading index series.
The bottom panel is my custom COT (commitment of traders) index (in blue) with horizontal bullish (green) and bearish (red) extreme levels noted on the chart. The COT indicator helps identify the behavior of commercials and speculators and can be used to identify potential reversal points before they occur.
The ECRI made their initial recession call in September of 2011 (Red Oval in middle panel above). At the time, the WLIW and the equity indices were in a free-fall. However, the COT index was extremely bullish (bottom panel), which means that commercials were buying heavily as prices declined. This eventually provided the requisite support and set the stage for an impressive 12-month rally.
The WLIW began to increase almost immediately following ECRI's recession call (which had to be extremely frustrating). It did begin to turn down again in April of 2012, but recovered again in early July and has been rising rapidly ever since.
I am sure that the WLIW is only one of many tools the ECRI uses to forecast recessions, but the recent behavior of the WLIW does not currently appear to support ECRI's recession forecast. It will be interesting to follow the index going forward and to see how ECRI and Lakshman Achuthan respond to the latest economic data.
By the way, the observations above certainly do not mean that I am bullish on the equity market. The market is overbought (at least on an intermediate-term basis) and my COT indicator is extremely bearish. As noted above, the JP Morgan Manufacturing PMI is still signaling a worldwide recession and it appears that year-over-year earnings growth will be negative for Q3 2012.
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I too have been impressed with ECRI for many years, but their analytical process appears to have gone off the rails. It doesn’t help that their methodology is a black box, at least to outsiders. Fortunately, there’s a better way to develop guidance about the business cycle with a relatively high degree of confidence with full transparency by tracking a carefully selected, broad set of economic and financial indicators and plugging the data into a diffusion index. A picture’s worth a thousand words–take a look at the second graph in this update:
And translating the numbers into precise odds for estimating recession risk via a probit model:
Thank you for your comments and for sharing your research and insights into the business cycle. I reviewed your most recent discussion of the Capital Spectator Economic Trend Index (CS-ETI) as well as your description of using a probit model to help interpret the data.
I was very impressed with your results. I agree that it is much better to have full transparency – with access to every variable and the underlying calculation methodology. I also liked your use of an ARIMA model to forecast near-term changes in the CS – ETI as well as your discussion of “nowcasting.”
I have added a link to your site on my blogroll, but would also like your authorization to periodically post a screen shot of the latest Capital Spectator Economic Trend Index Graph (or probit model graph) and an occasional quote from your site.
In each case, I would attribute the work to you and provide a link back to your site. Please let me know if that would be acceptable.
Thank you again for your contribution to TraderEdge.Net.
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