In my last two articles, I presented a unique methodology for assessing the current economic environment and understanding how the economy has advanced towards past recessions. One of my objectives is to identify patterns that can help determine when a recession is likely to occur. There are obvious benefits for investors who can reallocate portfolios based on economic conditions.
I have dubbed the grid structure I created the Baseline and Rates of Change (BaR) Analysis Grid. If you are not familiar with the methodology, you can read my last article here.
The BaR goes beyond simple trend analysis and offers several important dimensions.
- Includes a broad array of economic indicators that correlate closely with the ups and downs of the business cycle and represent all aspects of the economy.
- Establishes a baseline that approximates a recession threshold for each economic measure.
- Takes a jumble of economic indicators and forms them into understandable pattern.
- Calculates the mean of coordinates ((MoC)), which signals the general condition of the economy. The MoC is especially useful when comparing grids from different periods of time.
A list of the economic indicators used, grid label abbreviations, and data sources can be found at the end of this article.
All of the grids have been replotted since my last article. I found a flaw with a couple of algorithms that were used to calculate the baseline and rate of change percentages. Correcting that error spread out some of the indicators on the vertical axis, which is actually more helpful. I also found some mistyped numbers. However, despite some data and formula adjustments, the grids tell the same story as was described in the last article. I also added indicators for temporary employment, small business optimism, and existing home sales to the 2001 analysis.
Finally, for some reason the economic indicators are not always assigned the same plot color from grid to grid, which is one reason why I have labeled the data points.
Patterns of Recessions
Thanks to the logic of the BaR, there is little surprise as to where the economic indicators and MoC will end up on a grid prior to a recession. As the economy weakens, the indicators move to the left and downward, pulling the MoC to the left and towards the baseline. The position of the MoC can be used to assess the relative strength of the economy and determine how close a recession might be.
In this article, I will use the BaR to diagram the path that the economy took as it weakened and moved towards the 2007 recession.
2007 Recession: 24 Months Before
Up until this point of the 2001 – 2007 business cycle, the average annualized real GDP growth rate had been 3.2 percent (these were the good old days). Starting in this quarter, 4Q 2005, until the start of the 2007 recession, the annualized growth rate slowed and averaged only 2.2 percent. For this quarter, GDP grew at an annual rate of 2.1 percent. The slowdown in the economy is evident in the grid.
>Although the MoC is relatively high, 28 percent, nine of the 18 indicators are on the left side of the grid, the negative trend side. Two of these indicators, vehicle sales and consumer sentiment, are below the baseline. A period article at cbsnews.com suggests that “elevated energy prices” due to Gulf Coast hurricanes had affected consumer spending, especially on big-ticket items like autos. This helps explain the position of consumer sentiment and vehicle sales.
The collapse of the housing market wasn't a factor yet. Measured by building permits, the housing market reached it peak in November 2005, one month prior to this grid.
Due to the negative trends, the MoC is on the verge of moving to the left side. A grid mapping that looks like this has the potential to become increasingly negative, or it could just as easily rebound if most indicators moved to the right side over the next few months. Either way, with the MoC at 28 percent on the vertical axis, the economy had a long way to go before it would be in recession territory.
2007 Recession: 15 Months Before
At 15 months before the 2007 recession, 10 of the indicators are now on the left side of the grid, and two (STLFSI and vehicle sales) are at the vertical grid line, leaving six indicators in the expansion grid. However, consumer sentiment is now above the baseline, and it is the only above-baseline indicator that is within 10 percent of the baseline. Notice the large negative trends for building permits and existing home sales. The housing market is becoming a factor. The MoC clarifies that the economy was slightly worse off than 9 months earlier, as seen by the fact that the MoC has moved onto the left side and shifted downward to 23 percent on the vertical scale.
>2007 Recession: 12 Months Before
The deterioration of the economy continues to be seen on this grid. Only three indicators are now in the expansion grid. The economy is not in a dire situation as none of the indicators are in the contraction grid, although vehicle sales could easily move that direction. Building permits and the Credit Managers' Index have the highest negative trends. The MoC is now 22 percent above the baseline.
>2007 Recession: 9 Months Before
Nine months prior to the recession, vehicles sales has moved into the contraction grid and the majority of the indicators are still on the negative rate of change side. Existing home sales has the highest negative rate of change. However, there are now six indicators in the expansion grid. The net result is that the MoC has shifted slightly to the left. The continuing negative trends of most indicators has shifted the MoC down to 19 percent on the vertical scale.
>2007 Recession: 6 Months Before
With the majority of the indicators staying on the left side of the grid, and two in the contraction zone, the MoC has shifted to leftward and is now 16 percent above the baseline, 12 percent less than it was at the 24-month mark. Building permits and existing home sales have the most negative rates of change, and existing home sales slipped below the baseline. Small business optimism is nearly at the baseline.
>2007 Recession: 3 Months Before
The yield curve spread (10-year T notes minus 3-month T bills) has always inverted roughly a year prior to a recession or a credit crunch (the last credit crunch was in the 1960s; since then it has inverted only before recessions). For this reason, I have pushed the yield curve spread forward by 12 months, which is consistent with the Cleveland Fed’s Yield-Curve-Predicted GDP Growth model. Of course, the yield curve spread doesn’t always invert exactly one year before a recession. If the yield curve spread is below the baseline as shown in this grid, then it inverted 15 months previously. Seeing the inverted yield curve spread here tells us what we want to know, there has been some serious financial stress in the economy, the type that normally precedes a recession.
>The 3-month grid may appear similar to the 6-month grid, but many indicators are closer to the baseline and three are below: yield curve spread, existing home sales, and building permits. In addition, existing home sales are plummeting. Another important change is the drop in the STLFSI. On prior grids, it was in the 30% range on the vertical axis. Now, it has dropped to around 10%. The MoC has a negative 11 percent rate of change and it is 11 percent above the baseline.
2007 Recession: 1 Month Before
In this grid, seven indicators are below the baseline, and several other are approaching it. The MoC has now shifted down to 6 percent on the vertical scale, a 5 percent drop in two months. For now, four indicators are in the expansion grid, but they will give away soon. They can't overcome this economic tsunami. This grid shows that when a recession is starting, some sectors of the economy may not be in recession mode. This is where the MoC proves useful. The weakened indicators far outweigh the stronger ones, and the MoC confirms this.
For most economic indicators, the baseline is an approximation of where an indicator will be as a recession approaches. Rarely is an indicator going to be in the same place at the start of each recession. Due to any number of variability factors, I would say that any indicator in the upper-left grid that is within 10 percent of the baseline is signaling trouble.
An observable and important pattern is that of the MoC steadily moving downward and to the left. Individual economic indicators can be fickle and subject to wide swings from month to month, or quarter to quarter. What leads a downturn in one recession might not lead the next. By averaging the coordinates of the key economic indicators, volatility becomes less significant and the overall trend of the economy becomes more apparent.
As will be seen in the next two articles, the position where the MoC is located in the above grid is in the same general range as what is seen one-month prior to the 2001 and 1990 recessions. This consistency confirms that the BaR is presenting economic data in a way that is meaningful and useful.
Legend and Data Sources
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Source : https://seekingalpha.com/article/4113269-economic-patterns-part-1-mapping-road-traveled-economy-prior-2007-recession