Individual investors are constantly bombarded with misinformation from nearly all media sources on almost every issue, but rarely is there a more paralyzing rumor than the infamous “double-dip recession.” For this reason, it is crucial for people to invest some time into understanding the nuance behind recessions and recession forecasting before before they go and invest their money.

First things first, it is important to know that – apart from being a scary buzzword – the word recession actually has a precise definition. According to the National Bureau of Economic Research:

“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. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

Flashback to 2008.

Due to the lag time between the present day and the day when accurate economic data becomes available, recession calls are almost always delayed by a matter of months. I expanded on this idea in a post called How to Win a Recession-Predicting Contest. In setting up this “contest,” I decided to handicap different categories of forecasters based on their methods and qualifications.

The Perma-Bears. Readers can submit their nominations, but quite a number of forecasters have been on the recession theme for more than a year. They are disqualified, unless they specified a starting point. October-November predictors. These entrants might win, if the NBER conditions are met. These are the pundits who have said for months that “we are already in a recession.” A better formulation of their comments might be that these conditions, if sustained for a long enough period, will eventually be judged as a recession by the NBER. The Deniers. There are several respected pundits who do not believe that current experience will constitute a recession. These include Rich Karlgaard, Vince Farrell, Gary D. Smith, Dick Green, Mark Perry, and David Malpass. These observers, all of whom we respect, note that current data are not actually at the levels of past recessions. We note that the NBER might deem this a recession if the pullback from the peak is great enough, broad enough, and long enough. The Probability Analysts. Some of our most thoughtful and respected sources consider the data and make forecasts in a careful fashion. These forecasts weigh probabilities, mostly the question of whether the NBER criteria will be met. They ask the question of whether the current economic weakness will eventually prove to be long enough and broad enough to meet the definition. This group includes two of our favorite sources, including the ECRI (recently calling the recession) and Econbrowser (with an ongoing evaluation).

The winner of the contest was somewhat counterintuitive. I said it would be a “pundit from two polar opposite groups: one calling the start in October or November or one predicting that no recession will occur. The reason? If this time period is ultimately deemed to be a recession, the dating will go back to the last peak. Those are the rules.”

The 2012 Series

At the beginning of 2012, I wrote a mini-series here on A Dash of Insight on how to evaluate recession forecasts and why it’s important to do so. In my post, “Why the Individual Investor is Bamboozled by Recession Forecasts,” I continued to outline some of the basic steps everyone should take when thinking critically about research. Before jumping to any conclusions, ensure the researcher has:

Provided a hypothesis, stated in advance; Explained the reason for the proposed statistical interaction; Demonstrated a real-time record of recession forecasting; and Maintained the same exact criteria over time (no fudging, changing, suggesting of Plan B or exceptions).

Later in the series I continued to offer advice on practical ways to review the pundits.In a post titled Evaluating Recession Forecasting: What Every Investor Must Know, I warned readers about the prevalence of factually correct but deceptive claims in financial news and blogs.

Many pundits, including some of the most famous and powerful, are playing fast and loose with the “R” word. John Hussman, a leader in keeping investors scared witless (TM OldProf eumphemism), now warns us that everyone else is looking at lagging or coincident indicators, and that we might all be blindsided by a recession. Here is a key argument: Let’s examine the seemingly most “compelling” data point first – the fact that December payrolls grew by 200,000. Surely that sort of jobs number is inconsistent with an oncoming recession. Isn’t it? Well, examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began. Let’s keep that one in mind for a moment while we consider another popular allegation. It goes like this: Mr. X (substitute nearly any mainstream analyst) thought that the economy was fine in December of 2007, the very month the recession was starting. These statements are accurate, but deceptive. Understanding why is crucial to an objective analysis of recession forecasting.

Based on the technical definitions set by the NBER as well as the lagging nature of accurate economic data, it should be clear exactly why this is the case.

In that same post, I went over my “acid test” for forecasting methodologies.

Openness — with the potential for peer review

Small number of input variables. Most people do not understand that “small is good.” If you have a lot of variables, it is easy to do back-fitting on a few cases. Beware.

Real-time performance. This means that you do not go back in history doing any data-mining. You create an indicator and live with it through time. (While the ECRI predictions are a matter of record, no one knows what changes they have made in their indicators).

After applying my own academic rigor to the plethora of recession forecasters in the financial blogosphere, I came to a definite conclusion on who is the best recession forecaster:

Robert F. Dieli and Mr. Model Most people think they know about recession forecasting, but they are often responding to someone’s last good call or who has the best PR team. The Dieli method hits a winning trifecta — it is based on sound intellectual premises, it has worked better than any other method in real time, and it is open for our review.

I go on to interview Robert Dieli in that post (link), which is certainly worth a readthrough in full. A few highlights:

Q: How much lead time do you usually see between a signal from Mr. Model and an economic peak or trough? The Aggregate Spread, which is the principal forecast statistic, operates with a constant nine month forward look. Unlike other leading indicators which operate with a variable lead time, the Aggregate Spreads looks ahead nine months at all times. Think of it in the same terms as the beam on the radar on your local weather channel. The historical record has shown that when the Aggregate Spread gets to 200 Basis Points, from either direction, we have reason to think there will be a cycle event (either a peak or a trough) some time in the time period nine months ahead of the arrival of the Aggregate Spread at the 200 Basis Point boundary. Q: Making those calls out nine months must lead to some interesting conversations with your clients. Indeed they do. For example, the signal for the peak of the 2001 recession that began in March of that year, came from model readings obtained in June of 2000. Telling folks, in the middle of the tech boom, that the business cycle had not been repealed and that we would have a recession the following year was a tough sell. Similarly, the indications that the recession of 2007 would end in the middle of 2009 began to emerge late in 2008 and in early 2009. Trying to tell folks that the economy would turn up while it was in the midst of what looked like a free fall in the first quarter of 2009 was even more difficult. But, because the model has the track record that it does, by the end of the first quarter of 2009 most of my readers were convinced that the worst of the recession was over and that a bottom would be forming. Q: To make this clear, while you talk about markets, you are not making market predictions. You are predicting the economy, right? That is correct. What I am out to do is anticipate the dates of business cycle turning points as determined by the National Bureau of Economic Research (NBER) with enough warning to allow effective planning. The stock market, the fixed-income market, and the housing market, to name just three, all have their own cycles. Sometimes those cycles match up closely with the NBER turning points, and other times they don’t. But you can’t know that until you know the NBER dates. The Aggregate Spread has an excellent record of showing, as much as a year ahead, when an NBER event is likely to take place. Armed with that information, and the specifics of their industry, or market, informed decision makers can make appropriate plans.

Moving forward, the one of the best resources I can recommend for investors concerned about upcoming recessions is Doug Short’s ongoing work. Not only has he chronicled the ECRI recession call, but also the continuing comments from critics. As usual, Doug provides a great package of charts to illustrate the key points.

While this will undoubtedly be an ongoing theme in financial news for the forseeable future, these tools should help you, the individual investor, to think straight and keep a level head when others buy in to the hysteria.

Linking to the Business Cycle

In this article, Drawing the Wrong Inferences from Economic Data, I explain how investors can profit from better understanding of recessions.

In general discussion and most media presentations, a recession is just a period of economic weakness. Most people think that we never emerged from the recession that started in 2007.

If you put aside the “R” word and instead think about the business cycle, it helps to see which investments are best at any given time.

On September 7, 2012, I analyzed current stock prices in the context of the fundamentals behind the economy. While many make the argument that the market is currently overvalued, I found that these claims were totally unfounded.

“May of 2008. Forward earnings on the S&P 500 then were 93.77, the ten-year yield was 3.9% and the odds of a recession — according to the best method — were nearly 100%

Now. Forward earnings are 108, the ten-year yield is 1.59% and the recession odds for the next year are below 10%.

People talk about headlines and sling around phrases like Draghi put, printing money, etc., instead of analyzing data. The world is a much better place for investing than it was in 2008…

All of the metrics are better now than they were at the prior market top. This is why stock prices increase over time — the fundamentals, defined correctly, get better.”

Refelecting on the 1987 market crash, I took some time to write about ways in which both this crash and the 2008 crash may have changed the mentality of investors for years to come.

“This most important lesson of the 1987 crash is not commonly understood. For the next few years, any stock system, whether based on fundamentals, technicals, or a computer program, had an acid test:

Did it call the crash?

We saw dozens of pitches. No one even bothered with a method that did not include a successful ‘crash call.’ The event was so important, and had such a great impact on results, that you could not make a persuasive case for a system that did not have a ‘tweak’ that would have predicted the crash.

Similarly, analysts who had given warnings were celebrated as heroes. This turned out to be fifteen minutes of fame for some.

This final lesson is probably the most important, and the most difficult to understand. Excessive emphasis on the ‘crash call’ warped the thinking of portfolio managers and individual investors alike. The life-changing events from 25 years ago punished some of the smartest traders and rewarded some of the, ahem, least skilled who happened to have the right position for the wrong reason.

Those who took the wrong lessons from this got to double down in lost opportunity. They followed the wrong gurus and the wrong systems for many years thereafter. They never recovered.

2008 is an echo of 1987. Another generation of investors may be lost.”

In early November of 2012, I took it upon myself to debunk the rumors surrounding a chart which allegedly showed definitive proof that a double dip recession would occur.

Rather than simply basing an abject conclusion off of the chart, I recommended bloggers actually take some time to read the research behind it.

“If you actually read the cited paper you would see the following points: The authors were trying to improve slightly on the NBER recession dating process — getting closer to real time. The authors recommended waiting until a reading of 80% was reached for three consecutive months to avoid excessive false positives. (P. 9 of the paper). At a minimum, if you are going to use your bully pulpit on the Internet to scare the daylights out of people, wouldn’t it be a good idea to confirm with the authors first? This is the downside of a world where no confirmation is required before publishing.”

It is worth noting that after contacting the authors of the paper from which this chart originated, both of them emailed me to confirm that my interpretation was correct – and the 100% chance of recession interpretation was completely baseless.

For further reading, visitors may be interested in checking out the yearly summaries of our Silver Bullet awards from 2013 and 2014. There are logical fallacies of many types in these posts, but you’ll find they disproportionately tend to involve some sort of imminent market crash.