Recession Introduction – Follow up

Although many people read the question about the probability of a recession, one year hence ceteris paribus, no one wanted to venture a public guess.  That is fine.

The point is that even strong market participants–hedge fund managers and active traders– do not know the normal expectation, even for an economy growing at trend.  Economists use something called a probit model to determine this.  At the risk of over-simplifying, instead of predicting GDP with an error band, the dependent variable is the probability of a recession, defined as two quarters of negative growth.  There is a more detailed explanation here.

For investors and traders the important point is that "normal" is 20%, according to a recent Fed study.  This means that when we think about the "right" PE ratio for the market — normal levels — there is a recession probability included.

The study also does a good job on the inversion of the yield curve.  The author, Jonathan H. Wright, concludes that the shape of the yield curve does not capture all of the relevant information.  The level of interest rates is also important.  Most of the yield inversions studied occur at much higher rates.  There is only one example similar to the current situation, and the rates there were a bit higher.  Anyone following "A Dash" will know that we have provided a lot of information to our readers on this point.