This article is probably the most exhaustive and challenging
piece I have written. It was worth the effort because understanding
the business cycle is crucial to making great investment decisions.
To get the full benefit, I urge readers to spend some time reading
the background links and watching the videos.
I am going to follow up with another piece describing how I use
this information for investment decisions. For now, let us all
focus on the method, understanding how and why it has worked so
well throughout history.
In May of 2011, I embarked on a search for the best recession
forecasting methods. I had been a long-time fan of the ECRI
approach. They were still very positive on the economy at the time,
and my quest was not driven by their conclusions. I was
uncomfortable with the methodology and the lack of transparency. I
had many reader suggestions, and I reviewed them all. The criteria
were stringent - "Jeff's Acid Test." The easy winner of this
Robert F. Dieli's
"Mr. Model." (
described the competition and the results).
The main conclusion from Bob's work was that there was no
imminent recession. This ran counter to some other well-publicized
and popular forecasts. Some readers complained in the comments that
the history of the forecast included some imperfections. Others
disagreed with the methods. The subject was too difficult for
simple responses to these questions. I promised to follow up in
more detail, but I wanted to do so in a convincing fashion.
A Year Later
A year later, some key elements of my rationale should be even
- Bob was right - once again, as so many times before. And he
did it in real time, not on a back-tested basis.
- Imperfections in real-time forecasting are acceptable - even
desirable. When I see a perfect forecast, it always means that
the model has been tweaked and changed to fit all of the past
- Simple is good. Methods that over-specify the number of
variables and numerical trigger points also imply excessive
back-fitting and poor predictability.
- Theory is important. The model should make sense.
Most recession forecasting models fail
because they emphasize weakness
. This is backwards. A recession begins at a business cycle peak,
something that I explain more carefully
. A recession starts with excessive strength. Seen any of that
Dr. Dieli explains this quite clearly in this chart.
(click to enlarge)
Your intuition about the business cycle would be better if you
completely forgot the "R" word and took Bob's lead: Substitute
"business cycle peak."
The key driver of Bob's forecast is what he calls the "Aggregate
Spread." By reviewing results over decades, we can see that this
method actually provides a warning of about nine months. The image
below describes the composition of the spread, using example data
(click to enlarge)
The most recent aggregate spread is shown below. Just as it did
last year, it provides strong evidence that the US economy is not
nearing a recession.
(click to enlarge)
And Now - The Show
Get some popcorn and your favorite beverage and settle back to
watch the show. I recently met with Bob Dieli to discuss economic
forecasting and to create some videos. The result is an eight-part
series in which we discuss each of the recessions of the latter
20th Century. [Thanks to Derek Miller for helping in the production
of the videos and producing the key summaries.]
In the first video, Bob and I discuss National Bureau of
Economic Research and why their definitions of a recession are
important. The nonpartisan NBER looks at both the peaks and troughs
of the business cycle to conclude when past recessions have
happened, effectively making "autopsies, rather than forecasts" -
as Bob says. Therefore, it is important for the Mr. Model to use
the same criteria when it forecasts for recessions, providing a
clearer picture than other models.
In part two, Bob and I take a close look at the recession of
1957. In doing so, they describe exactly how Mr. Model works. The
model signals 9 months ahead that the business cycle will be
heading towards a peak or trough when it crosses the 200 basis
points (shown as a red line on the chart).
Bob and I illustrate the ways in which policymakers can and do
impact the business cycle and how this interacts with Mr. Model. In
the run up to 1960, tightening by the Federal Reserve as well as
fiscal cuts by the Eisenhower Administration led to an economic
downturn. In 1967, when the Fed again tightened the yield curve,
the model signaled a recession. Shortly thereafter the Fed eased
up, thereby avoiding a recession. At the end of the day, the NBER
never called a recession in '67.
Mr. Model had nearly spotless performance in predicting the
recessions of the 1970s. Contrary to popular belief, the 1973
recession had less to do with OPEC and more to do with other
government policies that laid the foundation for an economic
Mr. Model shows the result of Fed Chairman Volcker's monetary
policy, which inverted the yield curve and brought the Fed funds
rate to 20%. The result was a short 6-month recession, then a short
recovery which was stifled by other policies. Interestingly enough,
the recovery never took Mr. Model past 200 basis points - meaning a
new peak could not have been established for the "second"
After the "double dip" recession of the 80s, the recovery
brought the business cycle to record highs. This led to the
third-longest period of economic expansion into the summer of 1990.
A combination of tightening monetary policy and changing policies
regarding the first war in Iraq were both responsible in part for
the downturn. In 2000, Mr. Model signaled a recession in an
election year - something that was sure to happen regardless of who
was elected. However, in both instances the model predicted short
and shallow recessions unlike the seriousness of the early 80s.
In the most recent recession, Mr. Model's results were decidedly
different than they had been for any previous recession. The model
alerted that the 200 basis point line had been crossed in 2007 but
did not decline sharply. This is in part because tightening by the
Fed did not affect the yield curve as they had in past events.
Quick reactions by the Bush and Obama administrations also helped
to prevent a dramatic decline in Mr. Model's basis points.
In this final video, Bob and I focus heavily on the 2007-2009
recession. The model appears to show a false positive as it crosses
the 200 basis point line in 2006, but continues sideways for some
time before the recession was officially called. In a sense, this
suggests severe instability rather than the dramatic declines of
the past. In any case, we had ample warning that a recession was
coming. It did not take us by surprise.
If you have studied the evidence, you will see that recessions
usually involve the Fed.
You might also have noticed that business cycle peaks do not
typically come from a problem of "stall speed" but one of excess
Market observers are completely mistaken:
- Wrong indicators;
- Wrong interpretation (weakness versus strength);
- Wrong sources;
- Wrong point of the business cycle; and finally
- Wrong stocks.
These will be the subjects of the next installment.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Why Global Economic Growth Will Benefit