The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through August 2017. The current 21-variable model has a diverse set of explanatory variables and is quite robust. Each of the explanatory variables has predictive power individually; when combined, the group of indicators is able to identify early recession warnings from a wide range of diverse market-based, fundamental, technical, and economic sources.
Several of the explanatory variables are market-based. These variables respond very quickly to changing market conditions and are never revised. This makes the Trader Edge recession model much more responsive than other recession models. The current and historical data in this report reflect the current model configuration with all 21 variables.
The Trader Edge diffusion index equals the percentage of independent variables indicating a recession. With the latest changes, there are now a total of 21 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 calculate the probit, logit, and neural network model forecasts.
The graph of the diffusion index from 1/1/2006 to 9/1/2017 is presented in Figure 1 below (in red - left axis). 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 U.S. economy flirted with entering a recession in early 2016, which was reflected in the deteriorating economic, fundamental, and especially market-based data. The diffusion index, slack index, and recession probability forecasts all captured the weakening conditions. However, the weakness proved to be temporary and the conditions and recession model forecasts have improved significantly in the past year. The number of variables indicating a recession is currently one out of 21 (4.75%), which decreased by one (4.75%) last month.
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 from the current data set.
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. Higher slack values signify larger cushions above recessionary threshold levels.
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.
In mid-2014, the revised median recession slack index peaked at 1.29, far above the warning level of 0.50. The recession slack index declined significantly in 2015 and reached a low 0.34 in February 2016, before rebounding over the next few months.
The recession slack index is currently 0.95, which is down sharply from last month's revised value of 1.15. The median recession slack index has now declined for three consecutive months and is at its lowest level since August 2016. The slack index is still materially above the early warning threshold, but the recent rapid decline is troubling.
To gain further insight into the slack index, I recently went back and calculated a derivative value: the percentage of variables with increasing slack each month. The possible values range from zero percent to 100 percent. Due to the monthly volatility, I provide the three-month moving average of the percentage of variables with increasing slack in Figure 3, but I personally monitor the monthly percentages as well.
Slack is a standardized value, so it is directly comparable across all variables. More slack indicates a larger cushion relative to a recessionary environment. As a result, we would like to see as many variables as possible with increasing slack. Given the diverse nature of the explanatory variables, it is unusual to see more than 60% of the variables with increasing slack or fewer than 40% of the variables with increasing slack. These extreme values are significant and predictive of the near-term direction of economic growth and often the equity market.
The most recent moving average percentages of variables with increasing slack were only 36.5% this month and last month, which were the lowest readings since February 2016. The very low percentages of explanatory variables with increasing slack is very troubling and could represent an early warning of further weakness in the market and/or the U.S. economy.
The breadth of weakness across variables in two consecutive months is notable and suggests an increasing risk of an equity market pullback in the near future. It is rare to see the moving average of increasing slack values fall below 40% and most instances are followed by significant short-term market declines. The market is especially vulnerable when trading at or near its highs, as it is now.
The ability to track small variations and trend changes over time illustrates the advantage of monitoring the continuous recession slack index. The new slack variable will provide additional insight into the near-term direction of the economy and should be used in conjunction with the median recession slack index.
While it is useful to track the actual recession slack index values and percentage of variables with increasing slack, the diffusion percentages and slack index 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 1/1/2006 to 9/01/2017 are depicted in Figure 4 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 20-30% for the aggregate recession model (green horizontal line).
The aggregate recession model probability estimate declined from 0.2% in July to 0.1% in August. According to the model, the probability that the U.S. is currently in a recession continues to be extremely remote.
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 1/1/2006 to 9/01/2017 are depicted in Figure 5 below, which uses the same format as Figure 4, 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 9/01/2017 was 5.4%, which was down 1.9% from last month's revised value of 7.3%.
January and February 2016 marked a potential tipping point in U.S. recession risk, but those conditions proved to be temporary. Conditions have improved significantly since early 2016. The decrease in recession risk has been supported by both market and non-market variables.
U.S. recession risk remains very low. However, the recent sharp decline in the median recession slack index and the very low percentages of variables with increasing slack in the past two months is particularly problematic. The recent levels have not been seen since early 2016.
As I have repeatedly emphasized, recessions are not the only source of pullbacks in the equity markets. The U.S. equity market continues to be overvalued and global event risk continues to be elevated. This recent MarketWatch article suggests that "There are only two other times in history when stocks were more expensive than today." On a related topic, Mark Hulbert's latest MarketWatch article demonstrated that the Russell 2000's current P/E ratio is actually 78.7, not the more commonly reported value of 25.6.
Unlike human prognosticators, the Trader Edge recession model is completely objective and has no ego. It is not burdened by the emotional need to defend past erroneous forecasts and will always consistently apply the insights gained from new data.
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