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May 21, 2009

S&P 500 Index Value and Wright Model B Probability of Recession Beginning in One Year's Time, 1990-2009 Responding to a reader request, Steve LeCompte of the CXO Advisory Group recently investigated whether or not the Reckoning the Odds of Recession tool on our site has any predictive power for determining the future of the value of the S&P 500. Could our recession prediction tool provide a solid sell signal ahead of a recession? Can it indicate when a recovery will come?

In analyzing whether the mathematical model developed by Jonathan Wright that lies behind our recession prediction tool has any value in timing the market, Steve calculated a number of potential correlations between the recession prediction model and future stock returns (the chart to the above right shows the overall correlation between the S&P 500 index and the probability of recession as determined by the recession prediction model. Doing this for forward time horizons of 1, 3, 6, 9 and 12 months, using monthly data. Here, he found that (emphasis ours):

... the correlation between probability of recession and 1-month future S&P 500 index returns is an insignificant 0.03. For horizons of 3 / 6 / 9 / 12 months, the correlations based on monthly data are 0.02 / -0.01 / -0.06 / -0.10. For these longer horizons, there is considerable overlap in stock return calculation intervals, and overlap can distort correlations. Using modeled probability of recession at an annual frequency (each January) the correlation between probability of recession and 12-month future S&P 500 index returns is 0.02. These correlations do not support a belief in any relationship between modeled probability of recession and future stock returns. In other words, scaling allocation of assets to stocks based on the modeled probability of recession is probably not worthwhile.

Next, Steve ran the numbers to see if trading based on when the recession prediction model would anticipate a 50% probability of recession one year in the future could beat a buy and hold trading strategy. Here's what he found (again, emphasis ours):

Since the series begins with the probability of recession over 50%, the timed strategy does not enter stocks until the end of January 1992. It subsequently exits stocks at the end of July 2000, re-enters stocks at the end of November 2001, exits at the end of February 2007 and re-enters at the end of April 2008. The cumulative values of the timed and buy-and-hold strategies are $34,237 and $26,523, respectively. Buy-and-hold leads for the first half of the sample, and the timed strategy leads for the second half. Other entry and exit thresholds produce different results.

This threshold test offers some evidence in support of timing based on the Wright Model Probability of Recession, but the number of trades (five) is so small that the test is not convincing. Extending the test period backward across additional recessions may generate more confident results (but older FFR targets can be squishy).

Cumulative Value of $10,000 Initial Investments Made at End of January 1990, Buy and Hold vs Wright Model B

In summary, very limited evidence suggests that the Wright Model Probability of Recession may have some value for timing the U.S. stock market based on recession probability thresholds but no value based on systematic variation of the modeled probability of recession.

Steve LeCompte's analysis largely agrees with our own view of using Wright's recession prediction model to anticipate the future of the stock market. However, we have found that in the most recent economic downturn that Wright's model can anticipate key dates either initiating large declines in the stock market or one-day plunges a year in advance. The following posts describe what we observed:

While we don't have a good understanding of the actual mechanism involved, what we think is behind our success at using Wright's Model B recession prediction model in anticipating these key deterioration points in the stock market is the trading strategy put in place by bond and stock investors as they reacted in real time to changes in the U.S. Treasury yield curve. Our best guess at this time is that stocks dropped as significantly as they did on 20 November 2008 and 20 January 2009 in direct response to the expiration of year-long options initiated by stock and bond traders as they hedged their positions as the Treasury yield curve briefly reversed re-establishing a positive spread between the 10-Year and 3-Month U.S. treasuries during late 2007 and early 2008.

It would make for an interesting project to mine through stock market and Wright Modeled Recession Probability history to see if the correlations we observed in 2007 and 2008 might apply to other periods as well.

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