What Is The ADS And Why Is It Signaling A Recession?
The bulk of my job as a portfolio manager is looking at the macro economic data to assess future risks to our portfolio allocations. While technical analysis controls our short term investment risk - it is the longer term macro outlook that most directly impacts our allocation models. Each day investors are bombarded by a tsunami of economic, poltical and financial data all of which can, and most likely will, have a very direct impact upon a portfolio of invested capital. One indicator that doesn't get much attention at all from the press is the Aruoba-Diebold-Scotti Business Condition Index. This index is published by the Philadelphia Federal Reserve and is described on their website:
"The Aruoba-Diebold-Scotti business conditions index is designed to track real business conditions at high frequency. Its underlying (seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment, industrial production, personal income less transfer payments, manufacturing and trade sales; and quarterly real GDP) blend high- and low-frequency information and stock and flow data. Both the ADS index and this web page are updated as data on the index's underlying components are released.
The average value of the ADS index is zero. Progressively bigger positive values indicate progressively better-than-average conditions, whereas progressively more negative values indicate progressively worse-than-average conditions. The ADS index may be used to compare business conditions at different times. A value of -3.0, for example, would indicate business conditions significantly worse than at any time in either the 1990-91 or the 2001 recession, during which the ADS index never dropped below -2.0"
As opposed to many of the other economic indicators that are used to try and distinguish the trend of the economy - this is a composite index of stock data and economic indicators. This data is observed at mixed frequencies and then compiled on a DAILY basis for the purposes of creating a "real-time" read on the economy. Of course, because of the real-time nature of the index it is quite noisy and volatile and hard to immediately garner any significant indications about the overall direction of the economy. For this reason I smooth the data with a 12-month average so we can more clearly see indications of weakness and the trend of the index overall. The recession indication provided by the ADS index has been fairly accurate with very few false signals along the way.
As you can see the index showed a risk of recession in 2011 as the economy slowed. However, as we discussed in "Second Recession Horseman Goes Down" during 2011 there was a culmination of events that prevented the economy from slipping into recession:
- The Japanese earthquake led to a manufacturing shutdown combined with the debt ceiling debate which caused a contraction in consumer spending. This led to pent up demand that was unleashed during the last two quarters of the year.
- Further boosting consumption was a fall in oil prices which gave an effective $30 billion tax credit to consumers.
- The warmest winter in 65 years allowed construction and manufacturing to continue through the winter months which skewed the seasonal adjustments to economic indicators, like employment, to the upside.
- Due to the exceptionally warm winter utility expenses declined sharply giving another ample effective tax credit to consumers.
- The Fed engaged in Operation Twist along with the ECB which launched two rounds of Long Term Refinancing Operations which supported the financial markets and boosted consumer confidence.
Importantly, notice none of these supports for the economy was organic but rather a simultaneous collision of artificial and one-time events that prevented a recession. The problem today is that outside artificial stimulus - the "mother nature" effect is not currently available as the composite indicator is again signaling a recession through the manufacturing side of the equation."
However, once again the index has slipped into levels that have normally been associated with recessionary drags in the economy. The difference currently is that, while Central Banks are flooding the system with liquidity, the economy is being impacted by the onset of a recession in Europe, a slowdown in China and rising input costs. More importantly is that the economic recovery that started in April of 2009 has clearly peaked and turned down.
One interesting data point, in reference to the economy of the entire 21st century, is that the economic strength has been substantially weaker than that of the past. The most recent peak coincides with the peaks of post 2001-2002 recession recovery despite massive amounts of stimulus, liquidity, credit and a housing bubble. In past economic recoveries the index, post recession, has generally reached a positive 0.5 reading or better before the next decline. In the past two cycles the index has barely been above zero. This tells us much about the strength of "jobless" economic recoveries.
However, there is still some subjectivity as to the accuracy of the index and the start and end of recessions. Therefore, to turn the ADS into a recession indicator I removed all of the values that are greater than negative 0.1 from the smoothed index. In this way we can get a better view of the accuracy of the index as a recessionary indicator. Whenever the ADS Business Conditions Index falls below -0.1 the economy has generally either been in, or was about to be in, a recession. With the current reading, as of October 3rd, of -0.119 the index is beginning to push levels that have normally been associated with a weaker economy going forward.
Since stocks are affected by a weaker economy through declining profit margins and earnings, which is why the stock market corrects by 30% on average during a recession, investors would have been well served to pay attention to this index in the past. It will be important in the coming weeks ahead that the ADS index turns back up above zero, otherwise, we may be talking about a much weaker economy in the coming months ahead.
The general consensus between the media, economists and the Federal Reserve, is that we are once again in a "soft patch" and that the economy will strengthen in the coming months particularly with the Fed engaged in a massive bond buying program.
As discussed in "GDP and Durable Goods - Heading Into A Recession?" we discussed how close to a recession we might be stating: "At the current time the U.S. economy is technically not in a recession. However, as we have shown many times in the past that can change very quickly within a given quarter. The trend of the data is clearly negative, and in many cases, is getting worse. However, economists, and analysts, are quick to dismiss the trend of the data due to the Fed's recent endeavors into further bond buying programs. However, as we discussed recently, there is little evidence that these programs have much effect on economic growth."
The ADS index is just another of the many economic indicators that are confirming the Fed's concerns that the economy is much weaker than most economists, and analysts, realize. The consistency of the deterioration accross a large swath of economic data is concerning especially in light of rising input costs which will dampen profit margins. Even with massive central bank intervention the economy could well continue to suffer at the expense of a global slowdown.