Windows Of Opportunity In Business Cycle Analysis

Amid all the recession talk of late, there’s a lot of chatter about the value of predicting these events. One line of reasoning advises that unless you’re capable of anticipating recessions with a fair amount of lead time, the situation is hopeless. Actually, no—reality is far more nuanced than this one-dimensional claim lets on. Different recessions dispatch different degrees of pain on different time schedules. As a result, there can be value in simply recognizing when recessions begin, as early as possible.

Life would be much easier, of course, if we could reliably forecast recessions well in advance and take defensive actions before the storm hits. But history is littered with failure here. What’s more, it’s never really clear if the claimed forecasting successes relied completely on a methodology vs. a bit of luck. In any case, the debate about predicting inspires looking for the telltale signs of economic slumps once the process has started and once the negative trend is clearly terminal. Designed properly, this approach can be quite effective, in part because it’s not subject to the higher error rates of pure forecasting. I outlined a test on this front last week, and the results come with an encouraging record. It’s not rocket science, but it’s effective, as I discuss in a book I’m writing on the topic. In any case, the world is awash in predictions; what’s missing is a robust model for recognizing that a recession is already upon us. That alone can’t solve all our troubles with macro, but it’s not worthless either.
Waiting for a recession to declare itself in convincing terms may seem like a pointless exercise, but in fact there’s often a chance to prepare for the worst—even after the storm has recently started pummeling us. Consider the Great Recession. By NBER’s estimate, January 2008 was the economy’s first full month of broad decline. My research suggests that by the spring of that year, the data was clearly revealing, in real time, that the economy was in trouble. But wasn’t the jig up in January? Hadn’t the window of opportunity already closed by the first of the year? Not necessarily.
As one test, let’s compare the stock market’s one-year rolling return for the first 12 months of Great Recession with its 3-, 5-, and 10-year annualized counterparts. One-year returns were already negative by the time the recession started in January. But a roughly 4% loss at the end of the year’s first month deteriorated dramatically as the recession unfolded. Meanwhile, the 3-, 5- and 10-year annualized returns for the S&P 500 remained positive through August 2008, offering investors a chance to preserve quite a bit of the gains earned previously before all hell broke loose in September 2008 and beyond.

Looking at a variety of economic indicators also reminds that the Great Recession’s pain didn’t arrive as an across-the-board bolt out of the blue early on. For instance, retail sales and new orders for durable goods held up surprisingly well during the first half of 2008. Although both series weakened as the year progressed, it was hardly the case that the worst of the contraction had struck in these corners at the beginning of the recession.

To be fair, the window of opportunity for defensive action, once a recession begins, can and does vary considerably through history. But it’s misleading to argue that all of the damage is always dispatched up front. That may be true for some financial indicators and/or economic series 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 started can offer a surprisingly powerful bit of strategic information. But there’s a catch: You have to be looking for it, and the search requires an analytical lens that’s somewhat different than the usual suspects that are deployed for predicting recessions.