Probability of Recession and Future Stock Returns
Posted in Economic Indicators
June 14, 2011
Some time ago, a reader suggested: “Political Calculations has a tool to ‘reckon the odds of U.S. recession in the next 12 months’ based on a formula developed by the Econobrowser from a paper entitled ‘The Yield Curve and Predicting Recessions’ by the Federal Reserve Board’s Jonathan Wright. What about looking at it the other way in trying to gauge the odds of recovery using the tool?” Focusing on the usefulness of the yield curve-based Wright Model (WM) for predicting stock market behavior, we relate its outputs to future stock market returns. Using monthly closes for the 10-year Treasury note yield, the 13-week Treasury bill (T-bill) yield, the Federal Funds Rate (FFR) and dividend-adjusted S&P 500 Depository Receipts (SPY) over the period January 1993 (SPY inception) through May 2011 (221 months), we find that:
The following chart compares the behavior of SPY and the WM odds of recession (as calculated by the tool described above) over the entire sample period. The largest peaks in odds of recession roughly coincide with stock market tops, but equities continue to decline after the odds of recession diminish. It is not obvious that an investor can use the odds of recession to improve performance.
For a closer look, we relate odds of recession to future stock market returns.
The following scatter plot relates SPY next-month total return to monthly WM odds of recession over the entire sample period. The Pearson correlation for the two series is 0.03 and the R-squared statistic 0.00, indicating no relationship.
Might there be some useful non-linearity in the relationship?
The next chart summarizes average SPY next-month total return by range of monthly WM odds of recession over the entire sample period. The progression is not systematic, undermining belief in a reliable relationship, but the highest range of recession odds (> 33%) produces the lowest average return.
Can an investor use the WM odds of recession to boost cumulative performance?
The final chart compares cumulative performance of $10,000 investments initiated at the end of January 1993 for three investment strategies:
- Buy and hold SPY.
- At the end of each month, invest a proportion of funds equal to the prior-month WM odds of recession in T-bills and the balance in SPY (WM Proportional).
- At the end of each month, invest all funds in T-bills if the prior-month WM odds of recession are above 33% and otherwise in SPY (WM Binary).
Calculations assume no trading frictions and reasonably accurate estimation of the odds of recession just before the monthly close at which the investor acts on the odds. Frictions would be more significant for strategy 2 than strategy 3. Calculations also ignore tax implications of trading.
Results suggest that, even on a frictionless basis, the WM Proportional strategy is of no value. The WM Binary strategy may convey a small edge, but it does not help avoid the sharp 2008-2009 bear market.
For reference, the average monthly returns for strategies 1 / 2 / 3 over the sample period are 0.75% / 0.70% / 0.76%, with standard deviations of monthly returns 4.4% / 4.0% / 4.2%.
In summary, evidence from simple tests does not support a belief that timing the U.S. stock market based on the Wright model for calculating the odds of a U.S. economic recession can substantially boost investment performance.
Cautions regarding findings include:
- As noted, trading frictions would reduce performance for the two timing strategies applying the odds of recession.
- The sample, in terms of number of recessions/bear markets, is very small and the results therefore of low confidence.
- The binary trading strategy based on an odds of recession threshold is subject to data snooping bias (even if only by casual inspection as above), which would tend to overstate expected performance.
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