Recession Model Forecast: 01-01-2020

Before I update the recession forecast, I want to share some new developments. First, I have decided not to return to teach in the MBA program at Carolina next year. I had hoped that teaching part-time would still allow me to continue all of my research and proprietary trading efforts, but that has not proven to be the case. While it is personally rewarding to work with the students, the opportunity cost of teaching is currently too high.

After completing my MBA derivatives class in December, I devoted the last six weeks to implementing new improvements to the recession models and to setting up a new high-powered Windows 10 laptop to replace my two Windows 7 desktop computers. Due to compatibility issues with Windows 10, this required new neural network software, which I use to make recession forecasts.

I began designing neural networks over 20 years ago, but I do not create new neural network models on a regular basis. As a result, I took this opportunity to get up to speed on the latest developments in AI, particularly deep learning and the corresponding new types of network layers, activation functions, and optimization algorithms. I also took two online classes and experimented with several different software packages. After researching AI platforms, I purchased one AI software suite and am also using a separate deep learning package that is currently available for free (and integrates with Python).

I have made several important improvements to the recession forecasting models. Over the past several years, I added a number of new explanatory variables and dropped a few others. As a result, I did not need to add any new variables at this time. However, I did implement a new approach to quantifying the trend in every explanatory variable. This approach smooths the trend calculation, which further reduces the impact of data outliers – an issue I discussed after the most recent Government shutdown. It also makes all of the trend calculations more robust by reducing the potential for over-fitting.

The original peak-trough neural network models were derived from the initial diffusion index. All of the new models are based on four explanatory variables: the original diffusion index, the 0.5 sigma diffusion index, the median recession slack index, and a moving average of the percentage of explanatory variables with increasing slack. I have discussed each of these metrics in past recession model reports. In addition to the latest values for each of these variables, the trends in these four variables (using the same approach used for the individual variables) are also input into the models. This results in a maximum of eight variables used in the new neural network peak-trough models.

Due to the complexity of the problem, I used neural network models exclusively to build the peak-trough models. As is always advisable with neural networks, I aggregate the results from a number of different neural network models to arrive at the peak-trough forecast. Each neural network has a different architecture, training set, activation function, or optimization algorithm, etc. In addition, I went to great pains to prevent the neural network models from over-fitting the data, including withholding validation and testing data sets and limiting the size of the network.

I also re-estimated the probit and logit functions (from a subset of the eight variables used as inputs for the neural networks) for the standard recession model (which forecasts the probability the U.S. economy is currently in a recession). This is a much easier problem than the peak-trough estimation. As a result, neural networks are not required for the standard recession model. The probit and logit functions were sufficiently powerful.

I am excited about the recession model improvements, which combine all of the new metrics I have implemented over the past few years, plus a number of new cutting-edge tools and techniques. All of the current and historical forecasts presented going forward will be based on the new models.

December Update

This article updates the diffusion indices, recession slack index, aggregate recession model, and aggregate peak-trough model through December 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

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Recession Model Forecast: 12-01-2019

The following article updates the diffusion indices, recession slack index, aggregate recession model, and aggregate peak-trough model through November 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

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Recession Model Forecast: 11-01-2019

The following article updates the diffusion indices, recession slack index, aggregate recession model, and aggregate peak-trough model through October 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

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Recession Model Forecast: 10-01-2019

The following article updates the diffusion indices, recession slack index, aggregate recession model, and aggregate peak-trough model through September 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

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Recession Model Forecast: 09-01-2019

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.

Monthly Update

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

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Recession Model Forecast: 08-01-2019

In addition to my full-time proprietary trading and research efforts, I have been teaching part-time as a Professor of the Practice at University of North Carolina's Kenan-Flagler Business School. I taught four courses in the 2018-2019 academic year: one full-year Applied Investment Management class and three separate Financial Derivatives classes. I began course preparation work about 18 months ago, and began teaching last August.

I reduced my teaching schedule this year to a single MBA derivatives class, which begins in October. This will provide a better balance between teaching and trading and will allow much more time for new research going forward.

In the past two months, I have developed, coded, tested, and implemented two new long-term proprietary strategies: one for commodity futures and one for currency futures. Both look quite promising. The additional time this month also allowed me to smooth the look-back periods for the explanatory variables in the recession model, which are reflected in this report. If I have time before I return to teach in October, I hope to test several new variables that I have been considering for the model.  Worst case, I will evaluate the new variables after the derivatives class ends.

The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through July 2019. 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. Continue reading

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Recession Model Forecast: 07-01-2019

The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through June 2019. 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. Continue reading

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Recession Model Forecast: 06-01-2019

The following article updates the diffusion index, recession slack index, aggregate recession model, and aggregate peak-trough model through May 2019. 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. Continue reading

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