Identifying when a Recession has started …

publisher

Even while it is being played out, the market crash of August 2011 is being touted as the “Crisis of Confidence” as it was driven by investor fear following the debacle that was the United States’ debt ceiling debate. As the markets capitulated  through early August, volatility increased to a level never seen before, even by some of the most experienced market traders.

RecessionBut the global market crash is not due to the weakness in the one economy. In addition to the ability of the United States being able to lower and service their national debt, Europe is undergoing its own financial crisis which reflects much the same problem that the US had dealt with at the height of the GFC in 2008. All we need to do is replace property debt with sovereign debt.

By definition, a Recession is a contraction in the business cycle where there is a general slowdown in economic activity. Many macroeconomic indicators can be used to identify economic weakness. These include:

  • Slowing Production as measured by GDP (Growth Domestic Product) growth
  • Rising Unemployment
  • A decrease in investment spending
  • Falling household incomes and business profits
  • Falling inflation
  • Rising bankruptcies

A recession is a self-reinforcing downturn in economic activity, when a drop in spending leads to cutbacks in production and thus jobs, triggering a loss of income that spreads across the country and from industry to industry, hurting sales and in turn feeding back into a further drop in production. A vicious cycle that feeds upon itself.

To accurately define that a recession is forming is a very fine art. For centuries, the smartest economists have failed to predict coming recessions. In fact, it is only in hindsight that a recession can clearly be defined.

Firstly, economic data is a lagging indicator. When analysing data that represents a whole country such as Australia or the United States, economic reports are not provided until weeks, sometimes more than a month, after the event.  Hence, we can only confirm what we may be experiencing after it has occurred.

Secondly, economic statistics are typically revised and adjusted. For GDP (Gross Domestic Product) for example, we receive a preliminary GDP report, the actual GDP report and then finally the final GDP report, spanning more than 2-months from the first to last revision.

In addition to this, the stock market is a leading indicator to economic performance Hence, it can be extremely confusing for the Mums & Dads in identifying whether or not a Recession is coming or if we are already in the depths of one.

So are we currently in a Recession?

To identify a Recession, we need some rules to help define one.

In 1975, statistician Julius Shiskin suggested several rules of thumb to define a recession, including “2 consecutive down quarters of GDP”. This single point of reference has become the standard measure in defining a Recession.  This has not always been perfect, as evidenced by the 2001 recession where this rule of thumb failed.

His original rules included:

  • A decline in real GNP for 2 consecutive quarters
  • A decline in industrial production over a 6-month period
  • A 1.5% decline in real GNP
  • A 1.5% decline in non-agricultural employment
  • A two-point rise in unemployment or at least 6%
  • A decline in non-agricultural employment in more than 75% of industries, as measured over 6-month spans, for 6 months or longer.

All of the above have since been negated by economists, but the general rule of thumb of 2 consecutive down quarters in GDP have stuck and is now the benchmark used globally. But reality is that a recession is not so simply defined.

The US National Bureau of Economic Research (NBER) defines an economic recession as:

“a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.

For this reason, a true measure of a recession needs to include analysis of:

1)     Output

2)     Employment

3)     Income, and

4)     Sales

Which is what we defined at the start of this article. To measure this, we like to use the Economic Clock.

As an economy moves through its economic cycle from Expansion to Peak and from Contraction to Recession, our list of economic indications help identify whether the economy is suitable for investment in Stocks, Property, or Cash. Using key economic indicators, we can plot around a 12-hour clock certain indications to help identify the state of the economy.

Recession Clock

The key points on the clock include:

  • The 12 o’clock Boom
  • The 6 o’clock Recession
  • The 9 o’clock Recovery (Expansion), and
  • The 3 o’clock Contraction

By plotting the results of economic indicators onto the clock, we can define whether or not the economy is in a Recession.

Research firms use complicated mathematical formulas to evaluate economic stability, and to produce expectations for performance. As you can imagine, tens of millions of dollars are spent in producing these results. And of course, there is some real validity that can be used to make investment decisions.

 

 

One such example is Moody’s Research who provide global economic data. The following chart is the latest depiction of global economic status available from their website:

Recession World Map

By their analysis, this map would suggest that majority of the world is in a strong Expanding environment. But as we all are aware, this is far from the truth.

Our opinion is that Australia is in a weak growth environment. There is the potential that we could fall into a Recession, but we require more evidence before this will be confirmed. The current status of the most recent data includes:

  • 1x quarter of negative GDP growth
  • Slightly increasing Unemployment with the expectation of a rise in coming months due to announced layoffs
  • Increased consumer savings resulting in decreasing investment
  • Company profits have remained relatively strong through 2nd quarter earnings announcements
  • Inflation continuing to rise slightly due to the cost of fuel, food and energy
  • Weak Property market

Unemployment is on the rise, and this has the potential to push us into a Recession. Especially following 1 quarter of negative GDP growth. But this had occurred due to the Japanese tsunami earlier in the year. Consumers are saving more rather than spending. And hence they are failing to invest. Yet, this has not been reflected in company profits.

For the United States, they are far closer to falling into a Recession, ticking nearly all the boxes. As the largest economy in the world, this presents a clear and present danger to developed nations, including Australia.

The third quarter of 2011 will be an interesting environment for us. If we do not see improvement in GDP and investment, then we will shift closer to a Recessionary situation. For stock investors, this means we need to take a precautionary approach to the markets, investing in those specific sectors that offer a defensive outlook.

Offcuts

Over the centuries, there have been numerous methodologies on how to define a recession. Some of the more predominant authors include:

  • John Maynard Keynes – Keynesian theory
  • Julius Shiskin
  • US National Bureau of Economic Research (NBER)

Keynesian theory suggests that in a normal economy, there is a high level of employment, and everyone is spending their earnings as usual. This means there is a circular low of money in the economy, as my spending becomes part of your earnings, and your spending becomes part of my earnings. But suppose something happens to shake consumer confidence in the economy. Worried consumers may then try to weather the coming economic hardship by saving their money. But because my spending is part of your earnings, my decision to hoard money makes things worse for you. And you, responding to your own difficult times, will start hoarding money too, making things even worse for me. So there’s a vicious circle at work here: people hoard money in difficult times, but times become more difficult when people hoard money.

Since 1998, Matthew has been involved in the Financial Services industry providing stock, option and CFD advisory services, trading advice, funds management and education services. Matt is an Authorised Representative of Halifax Investment Services, providing analysis and recommendations for trading Covered Calls in the US markets and using Exchange Traded Funds (ETFs) ...
Follow Matthew Brown on Google+

Leave a Reply

Your email address will not be published. Required fields are marked *

*

Get Access To Your Income On Demand Opportunities

Sign up to receive the latest income generating how-to's, and ASX and US market insights!

Where should we mail you our latest income generating how-to's, and ASX and US market insights!?