Hussman's recession call is still not validated

- by New Deal democrat

Last week I wrote that both ECRI's initial recession call and also John Hussman's recession warning criteria had been invalidated. Oversimplifying somewhat, Hussman's 4 crieteria were: (1) credit spreads wider than 6 months before; (2) the S&P 500 lower than 6 months before; (3) the ISM manufacturing index under 54 simultaneously with less than 1.3% YoY employment growth; and (4) a yield curve of less than 2.5%. As of last Friday, not only was the S&P not lower than it was 6 months before, it was actually at a 6 month high! Further, not only was the ISM manufacturing index above 54, but employment growth was also more than 1.3% higher YoY. I've also pointed out that the yield curve element of Hussman's formula was in place for twenty years running during the 20th century, simultaneous with the strongest GDP growth in the last 100 years.

In closing, I said that Hussman should at least explain why he believed his recession call was still valid. Put another way, what is the "off" switch for the above criteria, if it is different from the "on" switch?

This week Hussman spent a large part of his weekly market comment defending that call. His defense rests, as I understand it, on two grounds: (1) one or more criteria was violated in 2008 and the recession warning, obviously, was still valid; and (2) there is no "off" switch for the criteria, but rather, once "on," a cornucopia of bearish evidence may be invoked, and entirely different criteria, e.g., a positive ECRI growth WLI, signals the end of recession.

Before I go further, I should emphasize that Hussman defended his metrics on their merits, with no ad hominem attack on me. For my part, although I still disagree with him, he did make some valid points, and none of what follows should be taken as a personal attack on him. In fact, I think his shorthand indicator briefly summarized above is very helpful.

That being said, idea of an indicator that switches "on" but never "off" strikes me as not intellectually rigorous. Beyond that, if the ECRI indexes are the determinant of an indicator, I should just go directly by them and cut out Hussman as the middleman. That in the interim a cornucopia of evidence may be selected (cherry-picked?) in support of a conclusion strikes me as inherently subjective and unreliable.

Since I wasn't satisfied with Hussman's explanation, I decided to examine the 3 non-yield curve criteria on my own to determine what should cause them to switch from "on" to "off." (With long term yields under 2.5%, that element is likely to remain in effect for a long time to come). The results indicate that if a recession were to happen now, it would still be unprecedented under Hussman's own criteria.

As an initial note, Hussman's claim that the S&P 500 criteria was violated in May 2008 is not correct. The closest it came was 1426.63 on May 19, 2008, only 7 points below its level of 1433.27 on November 19, 2007. That being said, my research indicates that it is not uncommon at all for that index to be higher than 6 months previously either shortly before or after the onset of a recession. Similarly, it is not uncommon for credit spreads to meander higher or lower than 6 months before during all but the most serious economic turns.

What is uncommon -- in fact, almost non-existent -- is for either the ISM manufacturing index criteria or the employment criteria to be violated. Generally speaking, once the ISM index falls below 54 in advance of a recession, it continues to fall under 50 and only rises back above 54 after the recession is over. Similarly, once job growth falls below 1.3% in advance of a recession, it typically only rises back above that level well after the recession has passed.

In fact, each has occurred only once, and not simultaneously. In particular, in all cases but one, the YoY employment percentage change was falling on a 6 month smoothed basis in advance of every recession since the second world war. The sole exception was in 1953. Similarly, the only time the ISM index fell below 54 within 1 year of the onset of recession but rebounded back above it was in 1959 for two months. These are shown in the graph below (in which the ISM index is normed so that a reading of 54 on the index = 0, and payroll YoY% growth is also normed so that 1.3% YoY growth = 0):



To show you the full record, here is the same graph for the 1970s and early 1980s recessions:



And here is the same graph from 1989 to the present:



Note that in every other case, not only did the ISM index continue to fall, but the YoY% change in employment was also declining going into a recession. There is simply no precedent for a recession occurring while both the YoY% change of employment is improving, and simultaneously the ISM index rebounding above 54. Put another way, whether a recession happens or not, under the set of criteria Hussman himself has established, a precedent will be set. Only in retrospect will we know the answer.

Hussman's, ECRI's (initial) recession warnings invalidated

- by New Deal democrat

The two primary proponents of the view that a new recession is beginning have been ECRI and John Hussman. As of now, we can say that Hussman's own metric invalidates his recession call, and that ECRI's initial recession call was also inaccurate.

While I have great respect for ECRI, when they made their initial recession call in September 2011, I wondered if they had misinterpreted a transient if violent downturn in manufacturing and consumer confidence, due mainly to the debt ceiling debacle and the consequent downgrading of US bonds, for typical short term leading indicators of recession. We can now say that it indeed appears to have been the case.

ECRI issued its private recession warning to clients on or about September 23, and went public with the warning on September 30. Their statement was unequivocal, Laksham Achuthan saying that recession was "imminent," and that he was

confident that the recession either began in the third quarter, which ends today, or will begin in the fourth quarter....

"We may be in a recession today already, or it may start in the next month or two."

[CNBC video with quotation embedded here.]

Achuthan also made it clear that he was relying not on GDP, but rather on the traditional NBER standards for determining a recession: industrial production, payrolls, real retail sales, and real personal income.

Well, the 4th quarter data is in, and here's where those four metrics stand:



All four finished 2011 at post recession highs. While certainly revisions to data are frequent, it will take some serious revising to cause enough of this data to turn negative to claim that a recession did begin by the end of last year. While subsequently ECRI backtracked and has revised the call to say a recession will begin by the end of June, their initial call must be regarded as busted.

Now let's turn to John Hussman. On August 8, 2011, John Hussman officially issued his "recession warning," saying that

the composite of economic and financial evidence we presently observe has always and only been associated with ongoing or immediately impending recessions. This is not an opinion or a viewpoint, but a fact of the data. "Always and only" is the Bayesian equivalent of "certainty"

The evidence he cited is the following composite, which he had set forth one week earlier, on August 1, 2011. The composite -- updated with my comments in italics -- is as follows:

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.

NDD comment: this component is still in effect, as credit spreads have not significantly improved since falling in August, but this condition may be violated in about six weeks if there is no further deterioration.

2: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.

NDD comment: This condition has been violated as of one week ago. The S&P 500 is higher now than it was 6 months ago, and yesterday came within a hair of a 6 month high.

3: Weak ISM Purchasing Managers Index: PMI below 50, or,

3: (alternate): Moderating ISM and employment growth: PMI below 54, coupled with slowing employment growth: either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron's piece many years ago), or an unemployment rate up 0.4% or more from its 12-month low.

NDD comment: This condition has also been violated as of the January ISM report of 54.1. If January nonfarm payrolls exceed 122,000, there will be a second violation as payroll growth will be more than 1.3% YoY. The unemployment rate has fallen by 1/2% in the last half year.

4: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields if condition 3 is in effect, or any difference of less than 3.1% if 3(alternate) is in effect (again, this criterion doesn't create a strong risk of recession in and of itself).

NDD comment: This condition is still in effect. Of course, it was also in effect during most of the 1930's 10% YoY New Deal expansion, the entire 1940's, and the start of the 1950's -- coinciding with the strongest growth of the last 100 years.

Now, it's possible that there are differing levels for these 4 metrics signaling "recovery" for Hussman vs. their "recession" signals as claimed above, but if so Hussman should explain what those different recovery levels are. Otherwise, as of now, two of the four necessary metrics metrics making up his composite based on which he predicted an "imminent recesson" 6 months ago have been violated. Thus the original basis for his recession warning is also no longer valid.

As for the immediate future, the simple question is: can you really have a recession when housing (permits close to 3 year highs) and cars (sales at 3 1/2 year highs) won't play along? On a related note, this morning's initial jobless claims number of 367,000 was the first week not affected by seasonality, and tells us that the recent drop was very real. If the relationship between initial jobless claims numbers and payrolls for this recovery continues to hold, then we should expect January's payrolls report tomorrow to be similar to December's number -- generally, somewhere in the vicinity of +200,000.