Recession chatter is heating up again, largely for obvious reasons: several key economic indicators are flashing warning signs. The wobbly numbers have convinced some analysts that economic contraction in the near term is fate. We’ve been here before in recent years, only to discover that the recession warnings were wrong. Is it different this time? Will the economy finally succumb? No one really knows, which leaves us with only one question: How can we make an informed, probability-based estimate of recession risk?
There’s no simple answer, but there are guidelines. What follows is a primer on responsibly reviewing economic cycle data and wading through the sea of commentary that routinely flows past your eyes and ears.
Don’t jump to conclusions. The first rule: stay calm and beware of pundits shouting from the rooftop. Behavioral biases are constantly working against us in the pursuit of intelligent decisions on investing and economic analysis. One or two headlines by a popular columnist or media outlet has the potential to change our thinking in a flash. Beware! If you find yourself radically, suddenly shifting your outlook on the economy after reading the morning’s news, that’s a warning sign that you’re at high-risk of perception whipsaw. The US economy evolves slowly and so any sudden, dramatic changes in your perception of macro conditions are usually wrong.
Focus on a broad data set. Our wetware is highly susceptible to focusing on one or two indicators that appear to tell us everything that we need to know about the nearly $21 trillion US economy. It’s a tempting idea, largely because it relieves us of the burden of spending time and effort at analyzing multiple indicators and trying to discern patterns that represent the broad cyclical trend. But history strongly advises otherwise. If you find yourself changing your view because a popular economic or financial indicator has flipped, that’s usually a warning sign that you’re in need of contextual analytical therapy. The antidote: step back and consider a diversified set of indicators that can proxy for the economy overall.
Beware of the “experts.” Analyzing the business cycle is a dark art that’s often irrelevant. The US economy, after all, is expanding most of the time and so developing and maintaining the necessary skills and data sets that are required for informed analysis of recession signals tends to be an afterthought in the wider world. That all changes when some of the numbers look wobbly. Suddenly, the “experts” come out of the woodwork and everyone seems to offer an informed opinion on recession risk. The reality is that business cycle analysis is a specialty practice and relatively few develop and maintain the data sets and analytical focus that’s required for an informed evaluation of the macro trend. The proof is in the proverbial pudding. Even a cursory look at recession warnings over the past decade, for instance, will turn up countless references of warnings by seemingly authoritative sources that ended up being dead wrong.
Understand your business cycle expectations. There’s only one business cycle, but the needs and wants for consuming related analysis vary far and wide. A pension fund is looking for something quite different vs. a newly retired investor vs. a factory manager when it comes to weighing the odds of recession and expansion. It’s essential to think through what you’re looking for with business cycle analysis and how to find the relevant information you need. That starts by considering what, if anything, you’ll do once you have a high-confidence warning that a recession has started (or is about to start). Will you sell your risky assets and go to cash? Or will you make modest changes around the edges of your investment portfolio? Alternatively, if you’re intent on buying and holding for the long run, recessions may be largely irrelevant. Regardless of your strategy, it’s crucial to have a plan for how you expect to ride out a recession – before a recession strikes. Waiting to figure out a strategy during a downturn is almost always a recipe for trouble since the emotional stress linked to an economic contraction will influence your thinking. Far better to plot out your business cycle navigation when the economy is expanding and the stakes are still relatively low.
Recognize the fundamental trade-off for real-time recession analysis. There are many business cycle models for assessing recession risk, but they all require us to pick our poison between two competing factors: timeliness vs. reliability. At the extremes, each side of this business cycle coin is worthless as a practical matter. Consider the gold standard for reliability: the National Bureau of Economic Research (NBER), the quasi-official arbiter of US economic cycle start and end dates. As a reliable measure of the cycle, NBER data is second to none. As a practical tool for managing assets and making business decisions, however, it’s useless. By prioritizing reliability above all else, NBER issues its proclamations well after turning points in the economy. The question is how to add a timeliness factor to the analysis? That’s another way of asking: How much reliability are you willing to give up in favor of timeliness? If you go all the way, you’ll have extremely timely recession warnings that are almost always wrong. The challenge is finding the right mix. Minds will differ on where the sweet spot lies. Keep in mind that the ideal mix will vary, depending on a variety of factors, such as your objectives and ability to tolerate economic blowback during downturns. Nonetheless, it’s important to consider where you fall on the spectrum in the search for a relatively high degree of reliability that’s timely and, critically, works for you. There’s no simple answer, in part because everyone’s needs and expectations for recession analysis varies.
Use a robust baseline for reference. Analyzing the business cycle can get complicated, but if you’re not prepared to go down the rabbit hole then it’s best to consider watching a robust benchmark for context. Perhaps the best place to start is with the 3-month average of the Chicago Fed National Activity Index. As I discussed in my book on estimating recession risk, the Chicago Fed’s business cycle benchmark has an encouraging track record of issuing accurate recession warnings in a timely fashion (based on vintage data). As an added bonus, the data is free. The drawback: the reports are published monthly with a bit of a lag. The good news is that we can anticipate the signals by a few weeks with a robust methodology, which is the focus of the weekly updates of The US Business Cycle Risk Report.
Recognize that the best recession analysis will focus on the recent past. As a responsible consumer of business cycle analysis you must recognize that no one can reliably forecast the future for the broad economic trend beyond one to two months. And even that deserves a fair degree of skepticism. The reason is obvious: a lot can change between today and six months from now. So when you hear someone speak authoritatively about what’s likely to happen for the economy a year from now, nod politely and quietly remind yourself that they have no basis for making that claim. By contrast, nowcasting and backcasting can be highly accurate tools for assessing recession risk in real time. That assumes, of course, that the underlying model is intelligently designed.
What’s the model? Finally, whenever you encounter a new batch of business cycle analysis that appears useful, it’s essential to understand the underlying model, if any, that drives the output. Ideally, there’s an elevator speech. Any analyst worthy of the name should be able to tell you the controlling idea that makes the analysis worthy of your consideration. In short, what’s the model? If you can’t get a good answer, in 60 seconds or less, it’s probably because there isn’t one. That’s a worrisome sign — and a strong hint that it’s time to look elsewhere for consuming business cycle analysis.