HOW TO PREDICT A RECESSION BEFORE IT

HAPPENS
By definition, a recession is two consecutive quarters of negative GDP. A
recession is not a sharp decline in the stock market or consecutive months
of negative returns in the stock market.Two recessions very close together
are often called a “double dip,” or W-shaped, recession.
So how can we spot the next recession before it happens and protect our
portfolios? The short answer is no, but you can monitor key economic
indicators to see where we are in the business cycle. The business cycle is
the natural progression of the economy and consists of four phases:
expansion, peak, recession, and recovery. Knowing where we are in the
business cycle helps us make informed investment and business decisions.

Expansion
Company profits are growing, banks are loosening their lending standards,
unemployment is declining, and GDP is expanding.
investors call this a bull market.

Peak
Prices for all goods and services are reaching their all time highs,
consumers are more leveraged, GDP is not growing, but is not
declining yet either. Unemployment is very low and not declining
further.

Recession/Depression
GDP turns negative.
Unemployment starts to rise.
The price of assets such as real estate and cars declines.
The government may begin fiscal or monetary policy to stimulate the
economy.
A recession is when your neighbor is out of work and a depression is when
you are out of work.(An old saying)
Recessions involving housing market crashes tend to be deeper than other
recessions, and recovery takes longer (Great Recession of 2008).

Recovery
Investors start buying assets that declined in value during the recession;
businesses start to hire again; and unemployment begins to decline again.
This continues until the expansion phase.
NBER(National Bureau of Economic Reserch) measures
recession from the peak of the previous economic expansion — in other
words, the point at which growth first begins to turn downward — to when
the economy first turns upward from its lowest level. GDP growth can still
be negative when the curve changes direction, but according to NBER,
that’s when the recession ends and the economy starts to recover.

Reviewing economic indicators

Three types of indicators: leading, lagging, and coincident.
Leading indicators try to predict a future event, lagging indicators show
what happened in the past, and coincident indicators occur simultaneously
as the events.
Below are a handful of key indicators monitored by investors and the
Federal Reserve to predict the future direction of the economy.
Stock Market (leading), Unemployment (lagging), Yield Curve/Interest
Rates (leading), Loan Delinquencies (lagging).

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Gross Domestic Product (GDP)
Gross domestic product (GDP) is the total monetary or market
value of all the finished goods and services produced within a
country’s borders in a specific time period .
Real GDP takes into account the effects of inflation while nominal
GDP does not.
Balance of trade = Total Exports - Total Imports. If TE>TI, then we
have trade surplus else its opposite is trade deficit.
Real GDP is a better method for expressing long-term national
economic performance since it uses constant dollars.
Real GDP is calculated using a GDP price deflator, which is the
difference in prices between the current year and the base year.
For example, if prices rose by 5% since the base year, then the
deflator would be 1.05. Nominal GDP is divided by this deflator,
yielding real GDP.
GDP per capita can be stated in nominal, real (inflation-adjusted),
or purchasing power parity (PPP) terms.
If GDP growth rates accelerate, it may be a signal that the economy
is overheating and the central bank may seek to raise interest rates.
- GDP=C+G+I+NX where:
The expenditure approach:
C=Consumption, G=Government spending,
I=Investment, NX=Net exports.
Consumption refers to private consumption expenditures or consumer
spending. Government spending represents government consumption
expenditure and gross investment. Investment refers to private domestic
investment. Businesses spend money to invest in their business activities
(buy machinery). NX = Exports – Imports
- The production approach is essentially the reverse of the
expenditure approach.
- The income approach calculates the income earned by all
the factors of production in an economy, including the wages paid

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 to labor, the rent earned by land, the return on capital in the form of
interest, and corporate profits.
Gross national product (GNP) is a measurement of the overall production
of people or corporations native to a country, including those based
abroad. GNP excludes domestic production by foreigners.
Gross national income (GNI) is another measure of economic growth. It is
the sum of all income earned by citizens or nationals of a country
(regardless of whether the underlying economic activity takes place
domestically or abroad).
GNP uses the production approach, while GNI uses the income approach.
In an increasingly global economy, GNI has been put forward as a
potentially better metric for overall economic health than GDP.
Real per-capita GDP, adjusted for purchasing power parity, is a heavily
refined statistic to compare economies.
One interesting metric that investors can use to get a sense of the
valuation of an equity market is the ratio of total market capitalization to
GDP, expressed as a percentage.

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to
control the overall money supply and promote economic growth and
employ strategies such as revising interest rates and changing bank
reserve requirements.
Types: Expansionary and contractionary
Contractionary: Increases interest rates and limits the outstanding money
supply to slow growth and decrease inflation and decrease purchasing
power of money. During peak, reduces money circulation.
Expansionary: Grows economic activity by lowering interest rates.
Spending and borrowing increases. During recession, inc money circ.
With an increase in the money supply, the domestic currency becomes
cheaper than its foreign exchange.
Tools of MP: Open market operations, interest rates, reserve
requirements.

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What Is Fiscal Policy?
Fiscal policy refers to the use of government spending and tax
policies to influence economic conditions, especially
macroeconomic conditions.
During a recession, (expansionary) the government may lower tax rates or
increase spending to encourage demand and spur economic activity.
Conversely, to combat inflation, (contractionary) it may raise rates or cut
spending to cool down the economy.
Expansionary fiscal policy is usually characterized by deficit spending,
which occurs when government expenditures exceed receipts from taxes
and other sources.
Contractionary fiscal policy is characterized by budget surpluses. This
policy is rarely used, however, as it is hugely unpopular politically.

Recession Indicators Explained

A perfect recession indicator, by definition, must:
- Have a false-positive rate of 0%, meaning every time it predicts a
recession, a recession happens.
- Have a false-negative rate of 0%, meaning there is no chance of
a recession unless the indicator says so.
- Tell you in advance when a recession will happen.
Yield Curve:
i. Yield-curve inversions have a good track record of predicting
recessions and tend to give their signals with decent advance
notice.
ii. "Yield" refers to the rate of return offered by a fixed income
investment.
iii. A yield curve is the shape you get by plotting the yields of those
securities as a function of their time to maturity.
iv. That short/long comparison is interesting because economic
theory says (and market behavior generally demonstrates) that
long-term borrowing carries more risk than short-term borrowing,

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 and so therefore the interest rates for long-term bonds must be
higher than the rates for short-term bonds. But actual rates are set
by market forces. And every once in a rare while, economic
conditions are such that investors are willing to accept lower yields
for long-term bonds than for short-term ones. When that happens,
economists say the yield curve is "inverted" and some forecasters
start exclaiming, "The recession is coming! The recession is
coming!"
v. Even when accurate, it doesn't say whether those tougher times
will materialize in weeks, months or years.
GDP:
i. When GDP is shrinking sharply and/or consistently, that usually
means a recession is happening. Two consecutive quarters of
negative economic growth is a good rule of thumb to indicate a
recession
ii. But it's not that helpful in predicting recessions, since at best it
tells you "a recession is happening" and when it started.
Confidence indexes:
i. A confidence index is an intuitive way of measuring how people
and organizations are feeling about the economy: Researchers
randomly select a group of people and just ask, "How are you
feeling about the economy?"
ii. The best-known and most-watched confidence index is the
University of Michigan Index of Consumer Sentiment.
iii. Its 50 core questions produce a treasure trove of data for
economists and forecasters alike, but the key result is a single
number.
iv. When that number rises, it means survey respondents are feeling
more optimistic about the economy. When that number goes
down, it's a sign of increasing economic pessimism.
Real Income:
i. Real income is an inflation-adjusted way of measuring how much
purchasing power consumers have in their pockets.
ii. If real income starts declining, that can be a sign a recession is
coming.

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The federal reserve bank of New York’s recession probability
model:
i. A probability model, but based entirely on the yield curve.
ii. It does a good job of applying statistical models to historical
data in order to turn the yield curve's slope into an implied
probability of a recession in the next 12 months.
iii. A value of 0.5 or higher should signal a coming recession.
Manufacturing:
i. One of the most common economic indicators for
manufacturing is the ISM (Institute for Supply Management)
Manufacturing Index.
ii. The goal is to measure monthly changes in demand by polling
manufacturers about the demand they're experiencing at their
factories.
iii. ISM polls hundreds of purchasing managers at manufacturing
companies for this index, which is why sometimes it is referred
to as the PMI, or Purchasing Managers Index.
iv. Because the survey captures information about orders not
even started yet, it's often a good leading indicator for the
direction of the economy.
v. One critique of the ISM Manufacturing Index is that it's noisy,
sometimes predicting larger swings than the economy winds up
experiencing by exaggerating both positive and negative
signals.
Wholesale/Retail:
i. They usually measure retail sales in inflation-adjusted dollars,
which is useful because the first sign of an economic downturn
is sometimes a drop-off in consumer demand.
Stock Market:
i. The S&P 500, an index of 500 of America's largest companies, is
probably the most popular for this purpose.
ii. The main issue with the stock market is that it's a sensitive and
noisy.

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 iii. Sometimes stock market downturns are just corrections for spikes
based on unjustified enthusiasm. Sometimes they're based on
fears that never materialize.
Unemployment:
i. Unemployment is a powerful indicator but not one that's very
helpful in predicting recessions because job losses tend to happen
mid-recession, not at the outset or in advance.
ii. The most common metric is the official unemployment rate.
iii. When it goes up, that's bad, and when it goes down, that's good.
iv. More expansive measures of unemployment take into account
underemployment — how well the labor force is being utilized.
Someone working part-time but looking for full-time work or
someone in a job that's a poor match for their skills and is looking
for a job that makes better use of their talents and training would
be considered underemployed.
v. This is a more timely metric of how bad the labor market situation
was that week. Some turnover in labor markets is natural, and
very good economies might see weekly initial claims in the two- or
three-hundred thousands. In times of struggle, those numbers can
creep higher. Past recessions have seen initial claims jump to
almost 700,000 a week.
Housing and household:
i. Housing starts track the number of new residential construction
projects. When the number drops, it signifies a lack of demand
and/or investment in housing.
ii. If the cause of the oversupply was that builders overestimated
consumers' ability to buy homes, that's a possible recession
signal. But if builders had just ramped up production because
labor and materials were unusually inexpensive at the time, that
may not be a bad sign.
iii. Household formation describes the number of new family units
created. A "household" is usually defined as a group of people
living together and sharing resources.
iv. If household formation drops, it could be a sign that college
students and other young adults are living with their parents

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 instead of "leaving the nest" to start independent lives. That can
speak to parts of the economy that are already weak
Leading Economic Index(LEI):
i. As the LEI rises, it means the economy is doing better; a falling
LEI signals worsening conditions.
ii. LEI is a composite index of other economic indicators. It's put out
by The Conference Board, a nonprofit industry association that
conducts research on behalf of its members, which include a
majority of Fortune 500 companies.

Recession Causes Explained

 Structural shifts:
i. Workforces can't upgrade their skills and move overnight, and
economic responses to events take time.
ii. Structural shifts can be caused by governments implementing
policy changes.
iii. The most persistent structural shifts are often caused by
technological developments or external factors, like environmental
changes.
 Sudden changes in external economic conditions:
i. If an important widely used input, such as food or oil, suddenly
becomes scarcer and consequently more expensive, that can
trigger a recession as consumers and businesses struggle to
adapt.
ii. Most difficult to predict.
 Psychological factor:
i. Sometimes bad economic events happen because people think
they're going to happen.
ii. If everyone thinks stocks are going to go down, they sell their
stocks, causing stocks to go down. If people are afraid a bank
won't be able to cover its deposits, they rush to withdraw money
and cause the bank to run out of funds, etc.
 Financial factors:
i. Commercial banks : lending too much to borrowers with a poor
ability to pay back the loans, investment banks : using financial
engineering to mask the risks associated with certain investments,

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 and rating agencies : supposed watchdogs who gave high-quality
ratings to what turned out to be very risky investments.

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