How to Forecast and Manage a Recession

By David B. Armstrong, CFA | Oct 04, 2018 | Browse FAQ, Invest My Wealth, Weekly Market Commentary

As a passenger on a commercial aircraft, you probably don’t have an expert level of understanding of all the inputs that go into a safe flight.  You board the plane and just have confidence that everything has been taken care of by competent, well-trained people.  Here are a few things off the top of my head that go into a safe flight:

• Proper engine operation
• Hydraulics
• The skill of the pilot
• Air traffic controllers
• Plane maintenance records and cycle
• Airframe integrity
• Local airport tower operations
• Radar operations and anti-collision operations
• Radios

As passengers, we tend to look at the overall success rate of airlines taking off and landing without incident.  It’s a single simple gauge and ostensibly accounts for all of the specific inputs mentioned above, alleviating us from having to understand any of them.

When we fly, we forecast that we will have a safe flight based on an overall track record of safety rather than assessing the conditions of all the underlying details.

Investors should apply that same logic when looking at the likelihood of a recession.

Assessing the Likelihood of a Recession

First, let’s start with some inputs that are useful when evaluating and forecasting the probability of a recession. Below is a list of data we purchase to then incorporate into a single reading we use internally (more on that below) to assess the likelihood of a recession.  While there are only five listed, there are actually six different models of data because the first one includes both coincident and leading models.

1. Nine weekly coincident and leading indicators (indicators with 0-4-month lead time to a recession)
   1. Philly Feds’ Aurora Dieboldt Scotti Business Conditions Index
   2. Philly Feds’ Business Outlook Survey
   3. e-forecasting.com eLEI
   4. Monthly GDP index
   5. Our Monthly Leading Index (USMLI)
   6. Our Leading Employment Index
   7. Chicago Fed National Activity Index (CFNAI)
   8. Our Weekly Leading Index (WLEI)
   9. Our Leading Manufacturing Index
2. A weekly Recession Diffusion Index (0.5-1 month lead) – This measures a total count from 0-9 of the above indicators that are in their respective recession territories.
3. A weekly Recession Syndrome Diffusion Index (4-5 months lead) – This methodology finds thresholds for each of the nine indicators which they must fall below to contribute toward a “recession syndrome.“
4. A quarterly Anxiety Survey Index (0-1.5 months lead) – This is a recession probability index built from various surveys of professional forecasters including Wall Street economists, corporate economists, independent economists, and academics.
5. A monthly Headwinds Index (6-7 months lead) – This uses monthly leading index directional behavior (i.e. only looking at if the index rose or fell) to derive how much “headwinds” the economy is accumulating.

Say WHATTTTT?

Exactly!

Just as you don’t need to know what every switch in the cockpit does, investors don’t need to know all the ins and outs of the economic data above, how to read it or what it even means.

That’s our job.

We buy a lot of data, review it and then assess a single index reading to make things clear and easy to understand for investors.  It seems simple, but it is very effective because what investors really need to know is if the probability of a recession is increasing or decreasing.

LAUNCHING MONCON

People ask all the time when we think there will be a recession.  I can say for sure that we will have a recession…the problem is I don’t know when.  Clients and other readers are running “emotional fire drills,” but and they want to know we have a plan and they want to know what it is now.  While the yield curve has a great track record for alerting us to a future recession, it is not a good predictor of timing.  Recessions are the real killer of bull markets and we want a simple way to let people know where we sit on the topic.  This is why we have decided to publish a simple, multi-model based gauge.

Because I’m a Marine and was raised in the 80’s during the Cold War, I naturally think of DEFCON Levels or Defense Readiness Conditions. DEFCON 5 is peactime, and the U.S. Military is in their lowest state of readiness. DEFCON 1 is when nuclear war is imminent.

Modifying the DEFCON levels to MONCON levels (see what I did there, MONument Readiness CONditions?), we can create alerts that dictate when we react.

• MONCON 5 – This level signifies none of the six models above are in recession territory, hence no recession risk at this time. Monument is not taking any recession related action inside portfolios.
• MONCON 4 – One of the 6 models is in recession territory. This reading suggests that there is an average 6-month lead time to a recession start. Monument is at a heightened state of awareness. However, since it is not uncommon to see reversion to MONCON 5, no recession related action is taken, and investment strategies remain fully intact.
• MONCON 3 – Two of the 6 models are in recession territory. This suggests an average 4-month lead time to a recession.  Looking back at the data to the 1960’s, it is more common to see a progression to MONCON 2 than back to MONCON 4.  This is a trigger point when Monument will begin raising cash in all managed portfolios.
• MONCON 2 – Three of the 6 models are in recession territory.  MONCON 2 suggests an average 3-month lead time to a recession. We will continue to raise cash.
• MONCON 1 – Four of the 6 models are in recession territory. At this stage we see an average 1-month lead time to a recession. A recession is imminent. Monument will now look to begin re-deploying any raised cash back into the models.

We are currently at MONCON 5.

Looking Back

Looking back, this reading has been at MONCON 5 since August of 2009. It didn’t react to the situations in global and domestic issues like credit crises, the Gulf oil spill, the EU Crisis, the Debt Ceiling Crisis, the U.S. Credit downgrade, European debt problems, the U.S. Fiscal Cliff, the Boston Bombing, the Government Shutdown, ISIS, the oil price decline, terror attacks, the refugee crisis, the China Slowdown, Fed Rate Hikes, Brexit, the 2016 Election…

Why?  Because while all of those events were newsworthy, they didn’t shift the components that are in the 6 models of data we follow enough to move to MONCON 4.

It’s a good thing, too…because we never went into a panic and never changed our investment strategies.

Want proof?

I’m not suggesting that MONCON is a foolproof plan to perfectly time a future recession, but I am saying that we have a gauge and a plan that is based on data and not emotion – more than what a lot of other folks have.

If you are reading this and you feel like your current advisor does not have a plan to protect your wealth during a future recession, please reach out to me directly— we can help.

Keep looking forward,

Dave

MASSIVE DISCLAIMER

Okay – MASSIVE DISCLAIMER. These MONCON levels are a collection of diversified recession forecasting methodologies.  They all differ in data, approach, and theory.  Because of that, we believe they collectively do a good job of offering a recession dating and forecasting approach that is resilient to “model risk.”

Recession forecasting is an art and not a science. There is no “one size fits all” model that has performed well in the past AND is guaranteed to perform well into the future. We feel that using a model is better than following opinions and our gut.  We feel that the best (and really the only) way to do that is by consulting a single gauge that is comprised of multiple robust models that are not overly correlated with each other in makeup or methodology.

Every recession is different. This is simply an overview of a gauge we use that we feel should be much more reliable than emotion, individual opinions on TV, fear or guesses.  People expect us to have a plan and we do…I just can’t promise it will work and you need to know that.  Anyone who says they have a foolproof recession indicator is either a charlatan or a fool.  But it’s a strategy for implementing action that I think is solid.

There are more disclaimers below from the lawyers, but this is my plain language one.

What’s Next?  Learn about Private Wealth Design.

Then Start Here

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Monument Wealth Management), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. All indexes referenced are unmanaged and cannot be invested into directly. The economic forecasts set forth may not develop as predicted. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Monument Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Monument Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of Monument Wealth Management’s current written disclosure statement discussing our advisory services and fees is available for review upon request.