The Economic Cycle Research Institute (ECRI) is one of the leaders in business cycle forecasting, but they had one spectacular and very public forecasting failure in the fall of 2011 - when they predicted an imminent U.S. recession. Until that time, ECRI had never missed a recession forecast. Given ECRI's flawless track record, in early 2012 I decided to override several timely and very profitable buy signals from my systematic equity strategies. The opportunity cost was significant.
I learned an important lesson from this experience. It is very difficult to integrate external, proprietary research tools and forecasts into my investment process. While ECRI's track record was impressive, their proprietary process was opaque. As a result, I had no way of understanding or evaluating their recession forecast or its implications for my strategies.
This realization led me to develop the Trader Edge recession forecasting models. These models may or may not be superior to ECRI's framework, but at least I know every input variable and the mechanics behind each of the Trader Edge model forecasts.
As you might expect, I am somewhat biased when it comes to ECRI, but I am disappointed that they never revised their recession forecast, despite data from their own weekly leading indicator series that directly contradicted their earlier recession forecast.
Instead of reevaluating their forecast, they recently published a new report based on nominal GDP growth that purports to support their recession forecast from almost two years earlier. Unfortunately, using nominal GDP growth (in periods with wildly different inflationary environments) to identify recessionary periods is not a fundamentally sound approach. This article explores this relationship in more detail.
S&P 500 Overvalued Based on Price to Sales Ratio
In a recent article "Earnings-Price Divergence Always Followed by Negative Returns," I noted that every extreme divergence (-20% or lower) between year-over-year corporate profits and equity prices in the past 50 plus years was followed by negative year-over-year equity returns. Unfortunately, the earnings-price divergence dropped to -21.3% during the quarter ended 9/30/2012. While the relationship between extreme earnings-price divergences and negative year-over-year equity returns is compelling, the elevated price-to-sales ratio for the S&P 500 index provides even greater evidence the market is currently overvalued.
Continue reading →