Has the LEI Given an All Clear Signal?

Last Thursday the Conference Board released the July reading of its Index of Leading Economic Indicators (LEI). Year-over-year it was up by 0.2 percent. This is the first reading in the plus column since 2007.

So … what does this clear improvement tell us? How important is it? Does it give us an all clear signal that a strong recovery is on its way?

The LEI Is a Very Successful
Recession Predictor …

The LEI is the most successful recession predictor I know of. It has forecast every recession since 1960, an accomplishment the vast majority of well-known economists and the Fed can only dream of.

Whenever the year-over-year percentage change fell below the zero line for three consecutive months, a recession followed suit. There was, however, one minor exception: In 1966 the LEI predicted a recession, but the economy technically barely averted one …

In 1966, the LEI stumbled. It had predicted a recession, but the economy technically barely averted one …

Growth slowed dramatically, earnings stumbled, and the stock market was hit hard. But according to the official arbiter of recessions, it wasn’t a recession. Even though for all practical intents and purposes it definitely felt like one — and in Europe it actually was a severe recession.

In 2007 a New
Pattern Emerged …

At the beginning of 2007 the LEI started to send warning signs. But its behavior was a little strange. The year-over-year change fell below zero. Then it rose back to positive readings, creating a pattern it had never done before …

In previous cycles it had always accelerated to the downside after getting negative for more than two months. This time, though, after a few months of soft landings, it fell below the zero line again, but now it was for real.

And for the rest of 2007 and all of 2008, the percent change of the LEI continually got much worse!

In November and December 2008 the LEI had fallen to -4.0 percent.
In January it recovered a little to -3.8 percent.
In February it went down to -3.9 percent and again to -4.0 percent in March.

Then it got better …

To -3.0 percent in April, -1.8 percent in May,
And -1.1 percent in June to the already mentioned +0.2 percent in July.

These numbers show that the turning point during the current cycle was between March and April 2009.

So in 2007 the LEI had done it again: For the eighth time since 1960 it had correctly forecast a recession.

The LEI Signals the End of the Recession —
But Nothing More …

After getting better three months in a row and rising above the zero line during the fourth month, the LEI is telling us that this severe recession will be over soon. That’s a positive message.

Although it does not tell us that a strong or long-lasting recovery is now in front of us. Yet that’s what most economists are saying! Many of these experts are the same ones who didn’t see the recession coming in the first place.

How do they know?

This isnâ€™t a garden variety post-WWII recession … the kind that almost always shows a strong rebound after a recession.

Well, they don’t, of course. They’re still hoping that this recession will finally turn out to be a garden variety post-WWII recession — which it isn’t by a mile. They hope for a repeat of the typical post-WWII business cycle pattern … the kind that almost always shows a strong rebound after a recession.

Only the events after the 1980 recession diverged from this script. Back then the LEI shot up to nearly 5 percent, but soon thereafter it relapsed into negative territory. Sure enough, the blossoming recovery was aborted, and another recession began by the end of 1981. And it was more severe than its predecessor and lasted much longer.

What does the history of the LEI tell us then?

It signals the end of the recession … and nothing more. It tells us nothing about the quality of the recovery — its length or its strength.

This Is Not a Garden Variety Recession —
Be Careful

This is obviously not a garden variety recession. It’s the result of a huge burst real estate bubble. Hence I deem it very dangerous to treat it like a normal post-WWII business cycle.

The real problems of the economy have not been solved by the Fed’s easy money policy, by the big bank rescues or by the stimulus programs …

The real problems — too much bad debt, overleverage, a sick banking sector, and an over-stretched consumer — are still with us. If history is any guide, a huge deleveraging process will weigh as a major negative on the economy for many years to come. That’s why the prediction of a normal and strong economic recovery seems to be based much more on hope than on reality.

For now, the worst of the post real estate bubble crisis seems to be over. That’s the message that the LEI currently confirms. But I suggest that you keep watching this recession predictor during the coming months … a new message could be given any time. And the long– awaited, stimulus-based recovery may turn out to be short lived.

Best wishes,

Claus

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