Book Excerpt | Nowcasting The Business Cycle | Preface

In the coming days I’ll be publishing passages from my new book–Nowcasting The Business Cycle: A Practical Guide For Spotting Business Cycle Peaks Ahead Of The Crowd. Let’s kick off the first of several excerpts with an obvious starting point… the beginning.

Preface

There are many victories worthy of celebration in the field of macroeconomics. Banishing the business cycle to the dustbin of history isn’t one of them.

Periods of economic contraction are inevitable, or as close to inevitable as anything in the world of macro can be. Enlightened policy by central banks and governments may be able to minimize the damage by restricting recessions to brief, relatively mild episodes. But the wisdom of anticipating even a limited degree of triumph in the war against the business cycle is debatable—again—after the Great Recession of 2007-2009 reordered expectations by reminding the world that old hazards die hard.

Some say that this is simply the nature of capitalism: boom and bust are as endemic to free-market economies as snow is to winter. Yet many economists insist that recessions can be engineered away, or at least strangled down to a manageable, low-level hazard—if only policymakers would make informed decisions. Maybe, but history isn’t kind to this brand of optimism, at least not so far. Governments have tried any number of techniques over the decades to test theories in the real world. So far the results are, well—let’s be generous and describe this history as mixed. The future may be different, but the case for thinking so still relies on wishful thinking rather than hard evidence.

Recessions, for reasons that aren’t fully understood, persist… despite the best-laid plans of economists and policymakers. That leaves two critical and forever-topical questions: When will the next slump strike, and how bad will it get? This book is concerned only with the first question. That’s more than enough to keep us busy. Searching for answers, or at least robust estimates of the potential for trouble, is among the more practical of pursuits in the sphere of economic analysis. If we can improve our appraisal of the fluctuating odds of recession risk, even slightly, we’ll be in a stronger position to prepare for the next storm and keep the fallout to a minimum.

Yes, there are already countless books on dissecting the economy, including a small library of titles that promise to unlock the secrets of predicting the twists and turns in the business cycle. Do we really need another one? Yes, for several reasons. First, the pages ahead concentrate exclusively on estimating recession risk in something approximating real time—soon after a contraction has started, which is to say before the downturn has inflicted the heaviest damage on your investments, your business, your career. Note the term “soon after.” We’d all like to know when a recession is coming before it’s arrived. Alas, that’s not possible (despite what you may have heard) and so we must settle for the next-best strategy.

In other words, don’t confuse the analytics on the pages ahead with forecasting so much as interpreting the economic numbers as currently published. The book in front of you is dedicated to developing and exploring a simple but effective method of assessing the economy’s vulnerability to contraction. Fortunately, we have a rich database to study and a long line of research to guide us.

Doesn’t a “simple” model doom us to failure? Not necessarily. “Just as the ability to devise simple but evocative models is the signature of the great scientist so overelaboration and overparameterization is often the mark of mediocrity,” the statistician George E. P. Box wrote.

The world is awash in sophisticated analytics that win awards, impress economists, and dazzle the intellect. But complexity and reliability aren’t always natural companions in the dark art of dissecting the business cycle, which has deceived more “experts” than any other phenomenon in the dismal science. But our quest isn’t hopeless, at least not entirely. For all the mistakes and misguided analyses, economists have still made progress in recent decades in probing the broad swings in the economy and so we’ll not be shy in embracing the available research when it helps us see the big-picture trend in clearer terms.

In any case, the stakes are certainly high. The business cycle is the main risk factor that drives success and failure in quite a lot of what unfolds in the modern world of business, finance and our personal lives as it relates to money and wealth. It’s not the only hazard, of course, but it’s an important one and sometimes it’s the dominant one, for good or ill. The old saying on Wall Street that genius is a bull market is an exaggeration, but there’s quite a bit of truth there. And the lesson applies well beyond money management. Whether you’re an individual investor watching over your retirement nest egg; the owner of a small business on Main Street; a manager running a billion-dollar pension fund; or a CEO in charge of a global corporation, we’re all in the same boat: a large portion of triumph and defeat is closely bound up with the broad swings in the economy.

It’s fair to say that the next recession may be the single-biggest complication for your career, your investments, your net worth, and so much more. Recognizing this truism means that we all need to spend more time thinking about and preparing for the dark side of economic destiny. The business cycle is the mother of all known (and recurring) risk factors. It’s essential that we focus on developing a process for assessing the likelihood of the threat. We need a reliable, timely warning system that’s relatively uncomplicated and transparent.

The business cycle looms large for everyone, individually and collectively, and it’s a positive influence… most of the time. The economy, after all, is usually growing. But sometimes it’s shrinking. We ignore the cycle’s capacity to reverse course every so often at considerable peril.

Some critics protest that trying to analyze the business cycle on any level is always condemned to failure. It certainly can be—if you’re trying to achieve the impossible. Efforts at forecasting the state of the economy for, say, six months or a year down the line are subject to a black hole of unknowns. No wonder that the track record generally for predicting economic activity is so poor. That’s hardly a shock. No one can see the future, and so it’s inevitable that even the smartest economists are regularly surprised.

A slightly more prudent (or less dangerous) approach is the focus of this book, and it can be summed up as follows: routinely read the economy’s signals (based on the latest numbers) and determine, as early as possible, when there’s a high probability that the economy has already slipped over the edge, or is in imminent danger of doing so. That may sound like a trivial advantage, but most people—including many economists—don’t fully recognize when a recession has started until the deterioration is obvious. By that point, the prime window of opportunity has probably closed for taking defensive measures in your personal accounts, your business, your portfolio, your career. But if we can learn the techniques for recognizing a cyclical downturn’s presence relatively early—soon after it’s begun, or just as it’s starting—we’ll have an advantage that tends to elude most folks.

The good news is that there are effective methods for assessing the current state of the business cycle—methods that provide timely warnings of when the economy has started rolling over to the dark side. This isn’t forecasting; instead, it’s recognizing when a majority of critical indicators have turned the corner overall. I call this nowcasting, or predicting the present, you might say. Or maybe we should call it backcasting, a reference to developing a sober view of what’s just happened.

Why do so many analysts miss these turning points until well after the storm has started raging? There are many reasons, although one is the tendency to forget that recessions creep up on us, like the proverbial thief in the night. If you’re not looking closely for the telltale signs of this party crasher, and doing so in a systematic, intelligent manner that’s grounded in empirical research, you’ll likely miss the warning signs of the early stages of economic decline. This point is often lost in the din of debate about the economic numbers du jour and fuzzy memories about what happened the last time the economy tanked.

Even if you’re looking closely, it’s essential to focus on a carefully selected and representative sample of data. No less critical is analyzing the numbers across time horizons that are long enough to minimize the short-term statistical and seasonal noise.

Quite a lot of people are under the impression that by the time a recession hits, it’s too late for defensive action. That may be true in some cases, but it’s far from a universal rule that applies to all economic slumps. Looking for a recession to declare itself, in convincing quantitative terms via published reports, quite often presents a chance to prepare for the worst that’s yet to come.

Consider the Great Recession. According to the official estimates from the National Bureau of Economic Research, January 2008 was the first full month of economic decline. By the spring of that year, the numbers were clearly showing that the economy was in trouble and that a new recession was already in progress. But hadn’t the window of opportunity already closed at that point for taking defensive action? Not necessarily.

As one test, let’s compare how the stock market’s trailing returns played out during the 12 months before and after the Great Recession began (Figure A.1). The ample gains that prevailed before the economy stumbled didn’t suddenly evaporate in the early months of 2008. As a result, recognizing early on—even as late as May or June—that a recession had started still left investors with a brief period to preserve a fair amount of any gains earned in the previous years.

FigureA1

Looking at a variety of economic indicators also reminds us that the Great Recession’s pain didn’t arrive as an across-the-board bolt out of the blue in January of that fateful year. For instance, retail sales and new orders for durable goods held up surprisingly well during the first half of 2008 (Figure A.2). Although both series weakened as the year progressed, the recession’s initial bite was relatively mild compared with the carnage that followed.

FigureA2

The window of opportunity for defensive action, once a recession begins, can and does vary considerably. But it’s hardly the case that all of the damage is invariably front-loaded. That may be true for some financial indicators or certain sectors of the economy in some recessions, but it’s far from an iron rule. In other words, developing a relatively reliable methodology for recognizing when a contraction has recently infected the broad economy in conspicuous terms represents a powerful piece of strategic information. But there’s a catch: You have to be looking, and the search requires an analytical lens that’s different from the usual tools that are deployed for predicting recessions. Yes, life would be much easier (and more profitable) if we anticipated recessions. But since no one can reliably muster such powers of prophecy, nowcasting is the only dependable game in town.
 

 
The forces that unleash recessions typically arrive quietly, building slowly, and spreading across various corners of the economy until the descent becomes broadly detrimental and patently obvious. As I discuss in the following chapters, cyclical tumbles are usually the byproduct of deterioration that’s built up in multiple parts of the economy—a decay that progressively deepens and expands, gradually reaching a tipping point of terminal decline. The problem is that during the initial period of decay it’s easy to be deluded into thinking that all’s well if you’re unsure of what to look for, or if you’re not looking at a broad set of key indicators through an appropriate statistical lens. But beware: there’s a huge amount of economic data to digest and most of it’s irrelevant, if not misleading, in the search for early, reliable signs of recession risk.

Looking to the usual suspects for guidance isn’t much help. For example, newspaper reports and the standard economic analytics aren’t usually productive resources for making strategic decisions about the risk of a new downturn. In fact, if you listen to commentary from the wider world, you’re sure to be whipsawed with conflicting interpretations on every new data point. Quite a lot of what you’ll read or hear is short-sighted, mistaken, and downright wrong. Historical perspective is essential for evaluating the business cycle, but you’ll have to dig deep to cut through the noise.

The news media, of course, is focused on headlines, drama, and how the number du jour relates to last month or the previous quarter. It’s also obvious that the analysts making the boldest claims tend to receive the most attention. News without proper context, however, tends to be deceptive at major turning points for the economy. It may be entertaining, but it’s not terribly helpful.

As for professional economists, a fair amount of the analytical efforts in the field are focused on projecting next month’s (or the next quarter’s) industrial production, unemployment, and so on. But quite a lot of this research is of limited value, if any, for estimating recession risk. Dismal scientists too often miss the forest for the trees. Keep in mind, too, that some economists may have a political axe to grind, particularly when a new election is approaching and it’s in their candidate’s interest to promote (or attack) the macro trend of the moment.

Objectively analyzing recession risk, in sum, is a highly specialized discipline. But because recessions are relatively rare, there’s minimal demand for this line of intelligence… most of the time. The few analysts who’ve mastered this specialty are in short supply, especially when their services are needed most: at the tail end of a long period of economic growth.

The task ahead, then, is working harder to identify those points when the cyclical clues are truly flashing red—and, no less important, figuring out when they’re not. The solution, in principle, is straightforward. Identify a range of the most productive cyclical signals, study the historical track records, and use the relevant studies in the research literature as a guide for developing a simple but effective process for analyzing incoming data in real time.

Doesn’t the economic profession already do this? Some analysts rise to this standard. But there’s still plenty of room for improvement, for reasons that will become obvious over the course of this book.

Remember, too, that even flawed methodologies are going to be right some of the time. But a system that suffers a high degree of false readings is hardly salvaged because it was right the last time.

The main goal is developing a model for generating high-confidence recession-risk signals. That’s a high standard. But compared with a lot of what’s already out there, it’s possible to move closer to this ideal, if only on the margins, in part because the competition on this front is generally unsatisfying.

Fortunately, some of the solutions for developing robust signals are uncomplicated, such as focusing on year-over-year trends to avoid the seasonal complications that can bedevil monthly reviews. Annual changes also help manage revision risk to a degree. Most economic reports are revised and so the initial estimates may be erroneous. Accordingly, it’s necessary to look at a range of key indicators to minimize the possibility that we’re being misled by the first cut of numbers. Another essential task is de-emphasizing forecasting per se; instead, concentrate on judging recession risk based on the data in hand—nowcasting. We can also look for corroboration with our conclusions from several of the published benchmarks that track broad economic activity.

How do we know where to begin and where to look? Researchers have supplied us with a broad guidelines through the decades. Even so, it’s easy to get sidetracked. With so much data available in the 21st century, and so many studies and analysts forecasting this or that, the risk of losing perspective is considerable in the miasma of information. The solution is to focus, focus, focus on the specific challenge of estimating recession risk.

Some aspects of this challenge can’t be resolved. We still can’t see around economic corners, no matter how hard we try or how much data we crunch. It’s an obvious point, but it still trips up analysts on a regular basis. The aim on the pages that follow is developing a high degree of assurance for recognizing when a new recession has started. That still requires a few assumptions about the immediate future. But the risk of error is considerably lower compared with the standard techniques if we’re looking for dependable signals about what’s recently changed. That’s a big difference compared with predicting what may (or may not) happen in the months ahead.

The primary source for thinking that we can do better is that researchers have continued to peel away the haze for recognizing when a new plunge has started. We may be long past the point of new discoveries that radically alter our ability to analyze recession risk. But the accumulated wisdom in macro analysis has inched onward, albeit in fits and starts.

Ultimately, we must focus on what’s essential, and ignore everything else. Most of us simply want to know when the odds of a new recession are relatively high. If there’s a hurricane coming, a bit of an advance warning that the storm is heading our way can be enormously helpful. But we must always be sensitive to the possibility of mistaking what appears to be a genuine threat when in fact it’s only noise or a temporary soft patch. Indeed, a system for predicting recessions that’s deeply flawed and prone to false alarms is worse than no system at all.

Finally, some readers may wonder why I don’t also analyze the techniques that are the counterpart to assessing recession risk, namely: looking for signs of a new expansion after an economic contraction has run its course. The short answer: anticipating a fresh bout of growth is considerably easier than searching for new slumps. The main clue for the next expansionary phase is the existence of a recession already in progress. When the economy’s shrinking, that’s been a reliable—virtually infallible—sign that a new upturn is approaching. True, there’s quite a bit of mystery about when, exactly, a recession will end and a subsequent rebound will start. In any case, that’s a subject for another book and, to be fair, it’s a less-problematic issue than looking for recessions. It’s the short-term interruptions in the expansionary trend that create so much trouble, in part because they come as a surprise for so many people. The good news is that we can do better with minimizing the surprise factor.

Growth, meanwhile, prevails in the long run and so our task is somewhat easier for anticipating the sunny side of the cycle. History is tenacious in reminding us that there’s probably a revival in the offing whenever the economy is suffering. I don’t want to diminish the real-time challenge of deciding when a new recovery is near. That’s still a tough act to pull off when a recession has us by the throat. On the other hand, there’s only so much one can fit into a single volume.

In any case, analyzing recessions is enough of a challenge on its own. Growth, by comparison, can (and usually does) take care of itself.

 * * *

Copyright © 2014 by James Picerno
All rights reserved. This excerpt contains material protected under International and Federal Copyright Laws and Treaties. Any unauthorized reprint or use of this material is prohibited. No part of this excerpt may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system without express written permission from the author / publisher.


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