Recession Model Forecast 08-01-2014

The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through July 2014. Please note that two new explanatory variables were added to the Trader Edge Recession Models in July.  For more information, please see "Two New Improvements to Trader Edge Recession Models."

Diffusion Index

The Trader Edge diffusion index equals the percentage of independent variables indicating a recession.  With the recent additions, there are now a total of 18 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 8/1/2014 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).

In February 2014, for the first time since the end of January 2013, one of the 18 explanatory variables indicated a recession.  The number of explanatory variables indicating a recession returned to zero in March and has remained at zero for the past five months.  If the number of variables implying a recession had continued to increase, that would have been a concern.  Instead, the variable that was pointing toward a recession moved back above its recession threshold level at the end of March 2014 and has remained there.

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.

Figure 1: Diffusion Index 08-01-2014

Figure 1: Diffusion Index 08-01-2014

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 gray shaded regions in Figure 2 below represent U.S. recessions as defined (after the fact) 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 back above 0.0.

Since emerging from the great recession, 0.74 (on 9/1/2012) was the lowest recorded value of the recession slack index. The recession slack index had declined significantly in early 2014 and the revised recession slack index value of 0.91 at the end of February 2014 was the lowest value since late 2012.   Had the decline in the recession slack index continued, the recession slack index could have approached the warning threshold of 0.50 standard deviations above the recession threshold.

Instead, the recession slack index increased from a revised value of 0.91 in February to 1.07 in March.  It then climbed above 1.30 in April and May, before dropping slightly below 1.20 in June and July.  The most recent value of the median recession slack index was 1.17, which is still well above the warning threshold.

The ability to track small variations and trend changes over time illustrates the advantage of monitoring the continuous recession slack index in addition to the diffusion index above, which moves in discrete steps.

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.

Figure 2: Median Recession Slack Index 08-01-2014

Figure 2: Median Recession Slack Index 08-01-2014

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 8/1/2014 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 8/1/2014 was 0.0%, which was unchanged from last month's revised estimate of 0.0%.  According to the model, the probability that the U.S. is currently in a recession continues to be extremely remote.

Figure 3: Aggregate Recession Model  08-01-2014

Figure 3: Aggregate Recession Model 08-01-2014

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 8/1/2014 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 8/1/2014 was 4.6%, which was unchanged from the revised value of 4.6% at the end of June.  The current peak-trough probability estimate of 4.6% is very low and remains significantly below the early warning threshold of 30%-40%.

Figure 4: Aggregate Peak-Trough Model 08-01-2014

Figure 4: Aggregate Peak-Trough Model 08-01-2014

Conclusion

U.S. recession risk declined in the second quarter of the year after a very short-lived increase in February.  The diffusion index declined in March and has remained at zero from April through July.  The recession slack index has declined slightly from its recent peak of 1.34 at the end of May to 1.17 at the end of July.  The peak-trough recession probability estimate decreased from a revised value of 8.5% in February to 4.6% at the end of July.  All of the forecast values are well inside their respective warning thresholds.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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