Wouldn't you like to know? The answer would be incredibly useful – especially since the clock on the wall says we are overdue. A downturn in the business cycle is one of the biggest risks we face, since our jobs, our portfolios, and our real estate all start circling the drain at the same time. Capitalism’s gale of creative destruction is great when it happens to the other guy but a fever swamp of flesh-eating bacteria when we have to crawl through it ourselves. Yet if we wait for a date from the National Bureau of Economic Research (which gets to decide such matters) it will be too late: we'll have long gray beards and the next recovery will be swinging. What we really need is an early warning signal when the Recession MIGs have crossed the DEW line so we can head for the fallout shelters.
That makes our person of interest James Picerno, who has written a terrific new book called Nowcasting the Business Cycle: A Practical Guide for Spotting Business Cycle Peaks. Trying to take the temperature of the economy in real time is fraught with peril, and Picerno approaches this task with skepticism, intelligence, and the most underrated virtue in finance, humility.
Picerno's book begins by walking us through the history of business cycle analysis to explore the nature of recessions. Then he examines a set of indicators that are the most revelatory about the economy’s condition right now. Among the tens of thousands of data series available, he picks fourteen to laser in on financial markets, employment, consumer spending, business activity, housing, and macro liquidity. He concludes by statistically combining these factors into a promising new model.
Does it work? Take a gander at this chart from page 119:
The vertical gray bars on the chart indicate times when the economy was in a recession, going back to the 1960s. One can't help but notice how Picerno's index correctly falls through the trap door into negative territory just as the bad times begin. Meanwhile, the positive values are associated with happy times of economic growth and prosperity. If this index proves to have predictive validity, it will give investors time to trim back their holdings in the stock market before it became a kill-zone.
[Squeezing useful data from an economist is harder than you might think. Once I tried to pick up an economist in a gray bar. I asked for her phone number, but all she gave me was an estimate.]
Those who want to skip the calculations can cue the answer by following Picerno's blog, the Capital Spectator. Meanwhile, he was kind enough to sit still while I pestered him with a few questions.
Q: You say that the distinction between predicting and nowcasting drives the logic of your book. Why is this important?
Picerno: Nowcasting focuses on interpreting the data published to date and analyzing what it means in terms of reading the "clues" about the business cycle vis-a-vis history. Although nowcasting is imperfect, the odds of generating relatively reliable signals about the state of the economy are considerably higher vs. guessing/forecasting what will happen down the road. In turn, developing robust nowcasting data is valuable because looking for periods when recession risk is unusually high offers timely information for recognizing that the business cycle is deteriorating. It'd be better, of course, if we could predict such events well in advance, but that's not possible and so nowcasting is the next best thing. Unfortunately, most of the attention is focused on forecasting, which misses the forest for the trees, so to speak.
Q: You look at the business cycle through the lens of three metrics: the Economic Trends Index (ETI), the Economic Momentum Index (EMI), and the Macro-Markets Risk Index (MMRI). What are these?
Picerno: The Economic Trends Index (ETI) is a diffusion index of 14 economic and financial indicators (industrial production, the stock market, etc.) that's based primarily on year-over-year percentage changes. When more than half are trending positive (i.e., the trailing one-year change is positive), that's historically been a strong clue for thinking that recession risk is low. By contrast, when less than half are trending positive, recession risk is elevated.
The Economic Momentum Index (EMI) measures the same 14 indicators but from the perspective of the median change for the annual percentage changes. Also, the raw values of both ETI and EMI are averaged over a three-month rolling period to smooth out any extreme values in any one month.
The Macro-Markets Risk Index (MMRI) is simply an index that looks solely at the markets-based components of ETI and EMI. Why look at the markets separately? Because the data is update in real time through the month and is immune to revisions. By contrast, economic data (retail sales, for instance) are published with a lag of one to two months and often revised.
Looking at the markets-based indexes for ETI and EMI offer an early hint at what the full set of economic numbers may reveal once they're published. Keep in mind that the markets can be wrong and subject to short-term noise. Nonetheless, big changes in the markets may alert us to trouble brewing in the macro reports.
Q: Walk us through where we stand with respect to your indicators today. Are we entering a recession? Or have the massive liquidity injections by the Federal Reserve made this impossible to diagnose?
Picerno: At the moment, the general trend for the economy remains positive, based on the latest data for ETI and EMI as of August 9. Both indicators are comfortably above their danger zones (50% for ETI, 0% for EMI). At the moment, July is the latest month with a broad set of economic and financial figures to analyze. August, by contrast, is still largely a mystery, although an early guesstimate via the markets looks encouraging. Nonetheless, monitoring the incoming data at this time is essential in the search for early warnings, should they arise. But first now, it's likely that July wasn't the start of a new recession for the US.
On the point of whether the Fed's keeping us out of recession, that's a great question. But that's a separate issue of where we are in the business cycle. For the moment, the economy is growing in broad terms, whatever the reason.
Q: Thank you, Mr. Picerno!
