Fourteen months after we
first warned of a recession, it's official. The U.S. economy slipped into recession eight months ago, in March 2001, just when
we at the Economic Cycle Research Institute concluded that a recession was no longer avoidable.
For future reference, it's important to consider two issues. One, why were most analysts so mistaken about recession prospects? Two, where do we go from here?
It's Tough to Predict Recessions
Three decades ago, the eminent business-cycle scholar (and my mentor) Geoffrey H. Moore commented that if you could predict a recession just when it was starting, you were doing very well as a forecaster. In other words, it really is very difficult to predict recessions.
But the way most economists do it makes it virtually impossible. This is because they essentially extrapolate past patterns into the future. This is an approach guaranteed to fail at turning points because that's precisely when the pattern changes.
What does work is a carefully selected set of leading indicators because, by definition, leading indicators turn down before recessions. But some economists swear by their own favorite leading indicators, and this is often a problem because there's no holy grail.
You see, every recession is unique and is caused by a different set of factors, though the number of such factors is limited. For example, this is the first business-led recession in the postwar era, so any forecaster who chose a single best leading indicator based on postwar data might have been led astray. Rather, it is important to select a whole array of leading indicators that cover the variety of cyclical processes that drive business cycles.
ECRI's Weekly Leading Index, or WLI, which represents such a combination, was virtually alone in correctly predicting this recession. The current version of the widely followed index of
leading economic indicators, or LEI, essentially failed to do so.
The reasons for this failure are twofold. One, the LEI does not represent the state of the art. Two, recent "improvements" have actually compromised its accuracy. I know something about this matter because Moore, ECRI's founder, created the original LEI back in the 1960s, and we have learned a few things since then.
The Road Ahead
Now that we are officially in a recession, is a recovery yet in sight? For the answer, we look again to the WLI, which typically turns up three months before a recovery, and turns down 11 months before a recession. This relatively short lead at business cycle troughs is typical of all leading indices.
The level of the WLI has actually climbed a little in the past few weeks, but that is not enough to predict an economic recovery because the rise in the WLI needs to be pronounced, pervasive and persistent. Thus far, the rise is pervasive, not very pronounced, and at five weeks, hardly persistent.
Under the circumstances, there is still a danger that the rise in stock prices since September may turn out to be a false dawn, like the rally last spring. Basically, it is still premature to predict a recovery.
How about the predictions we have all heard, about a recovery starting in the second half of 2002, say by next July, as one member of the official recession-dating group contended? Some people say that's what the market rally is looking forward to, across the valley.
Actually, a July 2002 recovery start date is an extremely bearish forecast that I would hesitate to make. This recession started last March, and a July 2002 recovery would make this a 16-month recession, matching the two most severe postwar recessions, in 1973-75 and 1981-82. That's not impossible, but it's hardly a bullish forecast.
If you look at the table, you'll find that contrary to what you might have heard, stock prices don't really turn up halfway through a recession, or six to eight months before a recovery. The record shows they almost always turn up three to five months before a recovery, often precisely four months ahead.
There are not many indicators that can anticipate a recovery as accurately as stock prices, assuming it's not a false dawn. So if July 2002 is indeed the recovery date, stock prices are likely to drop to new lows around next March, four months before that recovery begins.
If, on the other hand, September 2001 turns out to be the low for stock prices, it is likely that the advance in the WLI will eventually turn out to be pronounced, pervasive and persistent. If so, the U.S. economy will begin to recover around early 2002.
How will we know? The best way is to watch the WLI at
www.businesscycle.com every Friday afternoon to see if it keeps rising. If it does, stock prices are unlikely to fall to new lows.
But wait a minute, you might say. By the time the WLI tells us it's safe to jump into stocks, wouldn't you have missed the bottom in stock prices? Well, you certainly would have.
But the WLI is not designed to make you a perfect market timer. Rather, if used correctly, it will let you sleep at night by telling you clearly when there's a turning point ahead for the economy. In fact, if you had watched the WLI, you would probably have recognized a large rise in risk by September 2000. That would have been a few months after stock prices peaked in March 2000, to be sure, but you would still have avoided much of the bear market.
And if you can get into stocks once the WLI points to an economic recovery, you'll have missed out on part of the rally, but you'll be less likely to lose your shirt. Overall, your returns are not likely to be much less than a buy-and-hold strategy because you're also likely to be out of stocks during a significant part of each bear market.
So if you want to invest in stocks and still sleep at night, it might be a good idea to keep an eye on the WLI every Friday.
Anirvan Banerji is the director of research for the
Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at