As I mentioned last month, I will be teaching the MBA derivatives class again for the University of North Carolina's Kenan-Flagler Business School (KFBS). I reduced my teaching schedule this year to a single MBA derivatives class, which begins next month. This will provide a better balance between teaching and trading and will allow more time for new research going forward.
For the past year, I have been tracking several prospective explanatory variables for the Trader Edge recession model. Unfortunately, the demands of teaching at the KFBS last year did not leave me sufficient time to evaluate these new variables.
In the past month, I tested a number of prospective explanatory variables and I integrated six of these new variables into the recession model. They cover areas of the economy and market that were not adequately represented by the other variables, further expanding the breadth and robustness of the model. Increasing the number of explanatory variables reduces the discrete impact of each individual variable and also helps the model correctly identify different types of recessions that are triggered by a wider range of factors.
I also removed one explanatory variable that was based on the money supply. After evaluating many different money supply variables in the past month (independently and in combination with other variables), I concluded that the unprecedented level of central bank intervention has compromised the predictive value of these statistics for the foreseeable future. The new model has 26 explanatory variables: 21 from the previous model, plus six new variables, minus the money supply variable. I have also identified and am monitoring a few other variables that have explanatory power and are logical leading indicators of the US economy.
Due to the unique nature of the diffusion process and median slack variables, I do not re-estimate the general model coefficients or rebuild the neural network models when adding or removing variables. All of the current and historical data in this report reflects the current list of 26 variables.
While doing the above research, I was reminded again that the median and mean slack index values have been hovering just above the early warning threshold of 0.5 standard deviations for the past year. I thought it would be interesting to calculate the percentage of the explanatory variables that had already crossed below the 0.5-sigma early warning threshold. I calculated these values for the entire history and for the latest date. The new metric is called the 0.5-Sigma Diffusion Index. It is much more sensitive than the standard (zero-sigma) diffusion index. As a result, it provides much more granular detail on the health of the U.S. economy. I have not attempted to estimate probit, logit, or neural network models for the new 0.5 Sigma Diffusion Index, but it is an interesting potential area of future research. In the interim, I plan to include a chart for the new diffusion index every month.
The following article updates the diffusion indices, recession slack index, aggregate recession model, and aggregate peak-trough model through August 2019. The current 26-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 are available in real-time (no lag), which means they respond very quickly to changing market conditions. In addition, they are never revised. This makes the Trader Edge recession model more responsive than many recession models. The current and historical data in this report reflect the current model configuration with all 26 variables. Continue reading