Data-Driven Process for Anticipating Recessions
After going through the 2008 Financial Crisis, we decided to build a research process that warns of a recession before it happens. Our Business Cycle Indicator uses an advanced formula coupled with economic and financial market data to produce a real-time measure of the economy. The indicator has been tested as far back as 1968 and would have provided a warning prior to every recession. On average, the warnings came eight months prior to the start of a recession.
Over the last 50 years, recessions have occurred after our Business Cycle Indicator reaches a level of -0.9. On the other hand, a reading of +0.9 has been a strong sign that a recession is over.
Business Cycle Indicator: Why it Exists
When it comes to compounding returns, gains and losses of equal size are not equal at all. Understand that a 50% loss requires 100% in future gains to get back to even. If you suffer a really big loss, say 80%, it takes 400% in future gains to get back to even.
In the early 2000’s the Nasdaq fell 80% during the bursting of the Dotcom Bubble. During the 2008 Financial Crisis the banking sector fell 80% before having to be bailed out. These types of declines happen during recessions.
Our goal is not to try and “time” the short-term moves of the stock market. We are simply trying to avoid the really big declines that occur during recessions.
Business Cycle Indicator: How it Works
We combine six different components to create our Business Cycle Indicator. We use measures of monetary policy, corporate borrowing cost for both investment grade and non-investment grade companies, employment data, construction data, and even the number of heavy trucks that are sold each month.
The Yield Curve
Our Business Cycle Indicator uses the yield curve to measure how restrictive or accommodative monetary policy is at any point in time. Historically, the yield curve “inverts” (meaning short-term rates are higher than long-term rates) about 18 months prior to a recession.
Investment Grade Bond Spreads
Our Business Cycle Indicator tracks the spread between investment grade corporate bonds and risk-free bonds. As the economy begins to slow, investors opt for the safety of treasury bonds resulting in higher spreads. This is important because this has a direct impact of the borrowing costs for companies; higher spreads equal higher borrowing costs.
High Yield Bond Spreads
Similar to investment grade bonds mentioned above, our Business Cycle Indicator also looks at the spread on non-investment grade bonds (high yield). As investors begin to worry about the health of the economy, they typically sell these riskier bonds resulting is higher credit spreads. Higher spreads means companies have to pay higher interest rates to borrow money.
Initial Jobless Claims
Our Business Cycle Indicator also looks at the number of people filing for unemployment insurance each week. Naturally, as the economy begins to slow, the number of people filing for unemployment insurance tends to rise. On the other hand, when the economy is improving, the number tends to fall.
A big driver of economic activity is new construction. Our Business Cycle Indicator tracks the number of building permits issued each month. Before any new construction project gets started, the builders have to file for permits. This is a good leading indicator of future construction activity in the economy.
Heavy Truck Sales
Lastly, our Business Cycle Indicator tracks the number of heavy trucks (think “semi’s” or “Big Rigs”) that are sold each month. When the economy is expanding the demand for trucks grows. However, when it begins to slow, new truck sales tend to fall off quickly; often well before a recession starts.
Putting it All Together
For obvious reasons we don’t share the actual formula we use to produce our Business Cycle Indicator. The formula is so complex that it requires more than one million calculations to produce a single data point.
S&P Returns & Business Cycle Indicator
Our Business Cycle Indicator has a measurable history of 50 years. We went back and looked at the history of the S&P 500 over that same time period. The graph below shows the S&P 500 shaded in blue when our Business Cycle Indicator says the economy is expanding, and in red when it is warning of a recession. The grey areas on the chart are periods when the US economy is officially in a recession.
Dissecting Historical Returns
The table below summarizes the cumulative and annualized returns for the S&P 500 Price Index (excludes dividends) between 1968 and 2017. All of the positive returns in the S&P 500 occurred while our Business Cycle Indicator was suggesting the economy was expanding.
We also look at the history of the S&P 500 Total Return Index (includes dividends) between 1988 and 2017. Over this time period, the returns are even more impressive with the S&P 500 annualized 16.7% per year while our Business Cycle Indicator is in expansion.
Our portfolios page shows how we use our Business Cycle Indicator to build portfolios that are designed to protect investors from recessions.