Along with the news of an apparent final and comprehensive European solution last week was the the report that US GDP rose at an annual rate of 2.5% in the third quarter; higher than expected. Unfortunately, investors continued to follow the results of coincident and lagging indicators rather than leading indicators, so the positive GDP figure was taken as evidence that an oncoming economic downturn or slowdown was now "off the table."
We will emphasize that leading indicators are in fact leading evidence of the economy. As we know, past performance is not indicative of future results. For example, the ECRI Weekly Leading Index, which we discussed a few weeks ago, is continuing to point to a slowdown in growth. Of course, it's not a perfect indicator by itself, but its leading properties are useful. If you go back over the past few decades and look at the points where the index growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally below the five-year average at that time and took 3 to 4 months before unemployment claims climbed over the long-term average.
So the tendency for investors to make predictions from data such as this current data can be dangerous. It allows investors to be sucked in by temporary reprieves in periods where very negative conditions persist. Despite the variability in short-term outcomes, and the tendency for the market to advance as the economy declines, the overall implications are usually negative in terms of risk/reward.
The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest that recession risks still remain, and combinations of such indicators provide a basis for concern.
For example, since the early 1960's, when the ECRI Weekly Leading Index growth rate has been below -5, the economy has already been in recession approximately 80% of the time. If in addition, the S&P 500 Index was below its level of 6 months earlier, the economy was already in recession 87% of the time. Interestingly, when the index was below -7, and the S&P 500 was below its level from 6 months earlier, the U.S economy has been in a recession within 6 months, 100% of the time.
Now, we certainly don't base our economic expectations solely on these data points, as a broad array of other economic data points are mixed at the current time; however we want to be very aware of the data and historical statistical evidence. Therefore, we would view the sheer abandonment of a recession by the media, economists, as well as investors to be a bit misleading. Wall Street economists will quickly point to the summer of 2010, when the ECRI's Weekly Leading Index dropped below -10 without a subsequent recession, thanks we believe to the brief stimulative effect produced by QE2. Although the ECRI itself did not officially observe enough deterioration in its indicators to project a recession last summer. As we know it is currently projecting a U.S. recession in 2012 based on its leading indicators. To what degree is unknown at this time - it could be mild or more severe depending on outside shocks; or non-existent if the Federal Reserve steps in with another round of quantitative easing.
Given that nothing in economics is entirely certain, it's possible that this time will be different. We have seen a lot of firsts over the past few years. But that possibility is not one that has support in the data. To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time; given the current indicators. While we can't predict the future, it would seem prudent not to ignore this fact.
