The Second Differential Of The ECRI

The Second Differential Of The ECRI:

Last week the Economic Cycle Research Institute (ECRI) affirmed their call made last fall that the U.S. economy would soon be in recession.   The ECRI’s main business focus is to try and predict the ups and downs of the business cycle, and they have had an outstanding record over the years.  Right now the absolute level of the index may suggest economic weakness, but the second differential has suggested an improving stock market is also in the cards.    

The ECRI has developed a weekly indicator where they have combined various economic statistics into a series that they publish.  Details are not provided on the specific of the composition of this index, but they include broad measures of output, employment, income and sales.  When describing the weekly ECRI index, they always emphasize that these metrics are based on leading indicators rather than coincident indicators, so their data should carry more weight. No argument here, as we’d agree with this assessment.  

In an article written last week, they reiterated their call that a U.S. recession is forthcoming.  Confidence in this call was based on the year over year analysis of the weekly ECRI index, as it was again signaling weakness.  Year over year statistics help alleviate seasonality in the numbers, which has been a common complaint over recent months.  Again, we are not debating the merit of this argument, as this seems like solid reasoning.   But what we would say, is that investors may be better served to remember that the ECRI is predicting the economy, and not the stock market. These two are highly correlated, but certainly do not always move in the same direction together, except perhaps when you take the 2nd differential into consideration.  The 2nd differential is another way of saying, “less bad” data.  Less bad data (aka Green Shoots) is arguably what started the rally off the bottom in March 2009.

If you look at the chart above, the trends are fairly clear.   It’s not the absolute level of the data being positive or negative, it’s the trend of the numbers.   The market is not as forward thinking as most investors believe.   It moves up on data that is ‘less bad’ or better than it was previously, and moves down on ‘more bad’ or worse than the prior data before.

So it seems to us that the weekly  ECRI data series should be viewed differently when thinking about the economy versus the stock market.  The absolute numbers accurately reflect the overall economy, and the 2nd differential is a better reflection of the direction of the stock market.