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THEMATIC

Understanding
recessions
November 18, 2015
Contents
Trading and asset allocation around
recessions ....................................... 3
Economists and investors have a
terrible record forecasting recessions4
Why
do
economists
miss
recessions? ..................................... 7
Choosing leading indicators............. 7
Avoiding the vintage data problem... 9
Avoiding vintage data: using leading
indicators....................................... 12
Identifying recessions in realtime ... 13
Where are we now: four key charts to
watch ............................................ 17

In this report we provide an update on the current outlook for a recession in

the United States and we present a comprehensive view of how to forecast
recessions, protect your portfolio from them and even profit from them.
Economists are generally incapable of forecasting recessions or even of
understanding when they happen in real time. Economists fail for two main
reasons: 1) They rely on coincident to lagging economic indicators, and 2)
they rely on data that are useless in real time as it is heavily revised at a later
date.
Recessions are marked by a persistent, broad based and sharp downturn in
output, income and employment.
Here we provide a framework for
understanding recessions based on leading economic indicators.
Understanding when recessions start and end is not a trivial or academic
question. Downturns in economic activity typically precede large declines in
the stock market, a rally in bonds, a steepening of the yield curve, and a
spike in volatility. Being able to call recessions in real time is one of the best
tools an investor can have to protect a portfolio from losses and find high
risk/reward trades.
MACRO THEMES
> Identifying recessions in real time allows an investor to profit from
high risk-reward trades. The biggest reason to care about when a
recession starts is that the first few months of a recession typically
precede many months of severe, cascading equity losses. The largest
hits to any equity portfolio always happen at the beginning of recessions.

VP MACRO THEMATIC 11/18/2015 P.01

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> Economists are incapable of predicting recessions. All studies of

economic forecasts have shown that economists have an almost
unblemished record of missing downturns in economic activity. They
were incapable of forecasting them in advance and failed to identify
previous recessions. Most economists were not even able to recognize
recessions once they had already started.
> Forecasters generally just extrapolate current trends. Economists
tend to rely heavily on the persistence of trends in spending, output, and
the price level. One of the main reasons that economists have no clue
about the direction of the economy is that turning points are hard to
predict. Invariably economists miss turning points.
> Most economic data series are revised, which makes them useless
in real time. The revisions happen three, six or even twelve months later.
For some series, the updates are very small, but for others the changes
are huge, with the biggest changes for employment and GDP. The worst
news is that the revisions tend to be the largest at turning points. If youre
a central banker or an investor who is relying on accurate data to make
decisions based on the information at hand, relying on official estimates
seems pretty futile.
> Every recession is different, but they all share key elements in
common. The key to Variant Perceptions ability to understand the risks
to the economy and the appearance of recessions is that all the different
recession models look at markets and the economy from different angles,
yet they all feed into our main view of whether the economy is in a
recession or not. Our model allowed us to identify the beginning and end
of the 2008-2009 US recession in real time and would have worked well
over the past thirty years.
> Although we do not foresee an imminent US recession in the next 3
months, the risks have started rising. Most of our recession models
are not flagging danger, but two have started flashing red lights. Investors
should monitor leading indicators closely. We will keep an eye on: credit
spreads, building permits, yield curves and initial unemployment claims.
These series are leading and tend to turn before the economic cycle,
giving advance warning of recessions.

VP MACRO THEMATIC 11/18/2015 P.02

www.variantperception.com

GETTING THE MOST OUT OF THIS REPORT

If you want to skip ahead and find out what our current view on the probability of a recession is, you can go straight to page
17. There we provide our latest views.
In the next few pages, we explain how to understand recessions, how to forecast them, how to protect your portfolio from
them and how to profit from them.

If you would like a full copy of this report, please click here.
TRADING AND ASSET ALLOCATION AROUND RECESSIONS
Most traders and investors think a recession is two successive quarterly declines in GDP. This rule of thumb can be traced to
a 1974 New York Times article by Julius Shiskin, who provided a list of characteristics of recessions, including two down
quarters of GDP. Somehow, the two quarters idea stuck in the popular imagination. Recessions are marked by a persistent,
broad-based and sharp downturn in output, income and employment. The downturn does not need to involve consecutive
quarters (the recession in 2001 was not, for example), although most recessions last two to four quarters and are generally
consecutive.
Understanding when recessions start and end is not a trivial or academic question. Downturns in economic activity typically
precede large declines in the stock market, a rally in bonds, a steepening of the yield curve, and a spike on volatility. Being
able to call recessions in real-time, then, is one of the greatest tools an investor can have to protect a portfolio from losses
and find high risk-reward trades.
The biggest reason to care about when a recession starts is that the first few months of a recession typically precede many
months of severe, cascading equity losses. The largest hits to any equity portfolio always happen at the beginning of
recessions.

Source: Bloomberg and Variant Perception

Likewise, the biggest episodes of volatility also happen when the chances of a recession are rising rapidly. As you can see
from the following chart, the inputs to VPs Aggregate Recession model

VP MACRO THEMATIC 11/18/2015 P.03