Are we heading into a Recession?
Ever since we started our investing journey, most common prediction we hear is: “We are going to see a huge recession. Humans in general have a thing for end of economy scenarios — Everyone will struggle for jobs, wealth destruction and stock market is going to crash big”. Considering I started my journey in 2011, this has been predicted almost every 6 months, meanwhile Unemployment in US is at all-time historic low and S&P 500 returned 117.4% since then.
Till Jan 26, 2018. Journey has been up and right for stock markets for entire 2017. Then we had a 10% drop and everyone has panicked that world is going to end economically, forgetting that 117.4% everyone could have gained in last 8 years (Likely these people missed out on those gains and hoping it stops).
People have been blinded by 2008 carnage — Sub-Prime Mortgage crisis, which has eroded value from pension funds to home, unemployment and quality of life. 2008 recession is one of the most extreme economic events of our lifetime. I think it is going to be a while, not all recessions are same.
What is an Economic Recession?
2 consecutive quarters of decline in Real GDP.
Is it possible to predict economic recessions?
Surprisingly Yes, mainly because it is a term defined by humans to capture the downward spiral in economy. Which is a signal captured by lot of macro-economic data. we will see a couple of them in this post.
When was the last recession?
Dec 2007 — June 2009, National Board of Economic Research (NBER) tracks business cycles since 1854. Details here. The NBER does not define a recession in above terms. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
So what are the leading indicators?
We introduce 2 metrics which have historically worked as leading indicators.
Real Retail Sales
Defintion: Aggregated measure of sales of retail goods over a month.
US Census and Dept of Commerce capture in-store and catalog sales (includes e-commerce) from across categories like food and beverage to Automobiles. This is a big component of GDP. Released every month.
We can see in the below graph, Year over Year change goes negative before recession starts.
Industrial Production
Monthly reported by Federal reserve, raw volume of goods produced by industrial firms such as factories, mines and utilities — basically all manufacturing. It does not factor in the service economy or even construction. Again we see it dips to -ve during start of recession.
So its a simple model, when both numbers go less than zero, we need to worry.
So are we currently heading into a recession?
•Real Retail Sales (YoY) — 2.08% (march 2018)
•Industrial Production (YoY) — 4.32% (march 2018)
Metrics have been very well above 0 . So we are unlikely to be in a recession right now. So no need to worry yet ;) .
Isnt this data mining or does it really predict ?
Yes sort of data mining. That is the reason why we need to use multiple metrics from independent sources to build a more robust model. These metrics do not predict recession on a stand-alone basis. we need to combine with other information. Also none of these predicted twin peak recession caused by fed reserve in 1982. There are 10 other metrics we can use as recession indicators right from unemployment rate, personal income growth, Consumer Confidence
Only reason why we trust it —There are fewer false positives when we combine with other quantitative models. Remember our simple momentum strategy - 12 month return model in our previous post. So we can use that and couple with recession indicators to improve our prediction. S&P 500 is 13.76% up from YoY ago, so No WE ARE NOT HEADING INTO A RECESSION.
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