Drawing the Wrong Inferences from Economic Data
Most individual investors have missed the stock market rally — so far. Many hedgies are also lagging and finding excuses. The stories about the "headwinds" date back to Dow 10K, when the question was whether we would go to 5000 or Dow 20K. (I wrote two years ago, with a big skeptical reaction).
Why is it that so many have been so wrong and for so long. They were wrong about the economy and also the market impact?
I have been wrestling with this problem for a few months. There is a concept that I see as blindingly obvious, but it seems to elude the punditry. I think I have the answer, and I feel a little dumb for not seeing it before and explaining it better for my readers.
The late Murray Edelman who was my colleague when I taught at Wisconsin, had brilliant insights into communications and symbolism. He explained how powerful symbols focused attention — perhaps despite the merits.
Let us try to take this lesson.
A Few Questions
Here are a few questions about recessions. In each case, ask yourself whether a recession is more or less likely.
- Unemployment is very high.
- Interest rates are very low.
- Inflation is very low.
- Long-term bond yields are very low.
Most people correctly see all of these as signs of a weak economy, so they infer a high probability of a recession. This is exactly wrong!
People are quite correct in inferring economic weakness from these indicators, but they are wrong about forecasting a recession. Why?
The National Bureau of Economic Research (NBER), is the independent, non-governmental, non-partisan arbiter of recession dating. They do not attempt to date recessions in real time. Instead they wait for all of the revisions before providing the official verdict. This means that researchers who want to develop forecasting models have a solid endpoint for analysis.
They define a recession as the time between a business cycle peak and a cycle trough. You should do the same, since it is a valuable concept. It is much better than a soft discussion of headwinds.
Why You Should Care
There are two solid reasons to care about the "official" dating.
- Most pundits use the recession dating as part of their analysis. A prominent example is Jim Bianco who said nearly a year ago that a recession was more than a 50-50 chance. He also forecast a huge decline in corporate profits as a result. His analysis was completely dependent on whether or not we had an NBER recession. He was completely wrong in his warning, but no one seems to have noticed. Or maybe he was not wrong, since he said it was 50-50 — maybe yes or maybe no.
- The official dates tells you where we are in the business cycle. This is crucial for investors.
A Fresh Idea
The problem is that "recession" is a loaded term. It is defined in too many ways.
The "R" word has lost all useful meaning!
Some use the negative GDP for two quarters. Others just talk about whether things are bad. The financial media are no help, since they love to stick a microphone in front of anyone and use the "R word."
Why fight this? We all agree that growth rates are unacceptable, significantly below trend, and in need of improvement.
But this is social commentary and we must separate our opinions from the job of making successful investments.
If you want to make money, here is a simple rule:
Any time you hear "recession" you should substitute "business cycle peak."
Isn't that easy? If you make this substitution, and review the answers to the starting questions, you will realize that we have an economy that is slogging along, but has not peaked.
If you recalibrate your thinking from punditry discussions of headwinds and "slowing growth" to actual data analysis, you will increase your objectivity and also your investment results.
Forecasting Recessions — errr — Business Cycle Peaks
Now that we understand the importance of the business cycle peak (and trough) we can move on to analyze the success of the best forecasters like Bob Dieli.
As I do this, readers will understand why I insist on strict definitions of a recession, which starts at a business cycle peak.
While it may take me a few more weeks on this series, there is no mystery about the outcome. I freely share this in advance, so that the answer will not be too late.
- Those who are treating current conditions as an average recession and recovery are committing a serious blunder. These "cycle pundits" acknowledge that the recession is unusual, but still evaluate the recovery in terms of averages. Why the disparity?
- We are in the early stages of a long-cycle recovery. This is crucial for stock selection and explains why I like cyclicals and software stocks.
There are many names, but favorites include CAT, ITW, ORCL and INTC. I really like these stocks on a long-term basis, but I also see gains as traders reluctantly acknowledge economic improvement.