#116: The Sahm Rule Recession Indicator Speaks

S2N Spotlight

Over the weekend, the indicator that the financial media kept talking about over and over again was the Sahm Rule Recession Indicator. I wrote about this indicator in letter #97 on the 9th of July. It is worth a revisit; in fact, I watched a recent interview with economist Claudia Sahm a few hours ago.

Claudia developed the indicator while at the Brookings Institute, motivated to find an indicator that could declare the US in recession in REALTIME. The Fed implemented the indicator as part of their decision-making in 2019. The reason is that the economy is officially declared to be in recession by the National Bureau of Economic Research (NBER), a private nonprofit research organisation, usually 6–18 months after the actual recession has started.

Claudia Sahm wanted to create an indicator that took politics out of the Treasury’s decision to send welfare checks. Her research found that by the time a recession was declared and the government of the day got senate approval, they would be behind the curve and, in some cases, be so late as to pour fuel on the fire. If you listen to her, she is very clear in saying this is not a forecasting tool; it is simply an empirical artefact of history that is remarkably reliable. Her vision is that, based on this indicator, government officials can start sending welfare checks to people most in need at the best possible time without going through bureaucracy.

On Friday, the US economy officially triggered the realtime indicator with a read of 0.53. To save you the time of looking up the formula, here it is:

Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. To save you having to look up the current unemployment rate, it is 4.3% up from 4.1% in June.

If you look at the backtest below, the indicator on its own does not produce superior risk-adjusted returns than a buy and hold strategy. However, the red-sell markers on the S&P 500 chart below have been reasonable at timing an exit from the market since 2000. The pandemic recession being the anomaly.

Without going into too much detail, last Friday saw the release of the ISM PMI with a contracting economy reading of 46.6. It certainly seems that there is overall weakness in the economy at present.

S2N Observations

The markets took quite a beating last week, one of the biggest stories being the Japanese interest rates and the end of the carry trade. I really need to delve into this much deeper, but think of how it could impact the global capital markets.

Japan experimented with a crazy policy of zero interest rates for more than 30 years. This enabled people to borrow in yen for essentially zero and then invest in risk assets. With rates finally becoming positive, part of the trillion-dollar carry trade complex is starting to unwind.

Markets in the west and east are under pressure but it is Japan where I am seeing dramatic moves. The data I use is end-of-day but I am watching things unfold and thought I would get in early for a change as things are really quite dramatic.

We are currently witnessing the 4th time in 55 years that the Nikkei 225 Index is down more than 10% in a day. The returns post such an event for the 3 previous occasions are in the table below. This is not a statistically significant sample if you plan to rush out and buy based on the numbers.

I threw in for good measure a backtest when buying a 20% dip. Before the day started, the market was down 15%, but today took us into bear market territory. Once again, this on its own and holding for a year is not a superior risk-adjusted strategy. I am simply providing a naïve strategy using the DD threshold as a signal.

In my letter #97 a month ago that I referenced above, I said that it sure looks like the 2 year yield is heading down, and we can see if history is anything to go by that the Fed Funds rate will follow in quick succession. I think the probabilities are at 100% that the Fed will cut next month.

I was going to remark how brilliant Warren Buffet is and mention the massive crypto selloffs happening now but I will be back tomorrow rather for that.