With that track record, we were very interested to learn the latest macroeconomic predictions stemming from Russell's Business Cycle Index, subject to the disclaimer that the content does not constitute investment advice or projections of the stock market or any specific investment.

Current business cycle estimates suggest the economy was out of recession by August 2009; an anemic recovery and a false threat of a double dip await

Michael Dueker

The latent variable behind the NBER recession indicator in a Qual VAR model of recessions provides a useful business cycle index, where the distance above zero indicates the strength of an expansion or the distance below zero indicates the depth of a recession. The Qual VAR model (or this link) is designed to identify and characterize recessions in real time, based on the incoming financial and macroeconomic data, and it provides a framework for forecasting future business cycle developments. The particular data used in the estimation of the model are personal consumption expenditures, CPI inflation, the slope of the yield curve, the spread between 3-month commercial paper and Treasury bills, the spread between Baa and Aaa corporate bond yields and nonfarm payroll employment.

Starting this month, Russell Investments has adopted this business cycle measure as the Russell Business Cycle Index (BCI) and will post updated estimates of the Russell BCI and forecasts on the Helping Advisors site at Russell Investments. A real-time history of the business cycle index and its forecasts will be available in a spreadsheet.

For now, we can evaluate past performance of the business cycle model by noting that December's forecast of a July or August 2009 trough on Econbrowser appears to have been correct and by examining last December's forecasts of payroll employment. The figure below shows the path of payroll employment changes predicted by the Qual VAR model in the forecast posted on Econbrowser in early December 2008 along with the actual data since then. To date the actual pattern of job losses matches the forecast from December 2008 quite closely. In particular, the forecast last December was that the economy would lose about 4.9 million jobs between December 2008 and August 2009, whereas the data to date show a loss of about 4.5 million jobs.

Source: St. Louis Fed's FRED database for actual employment data and author's calculations. These macroeconomic forecasts do not constitute a projection of the stock market or of any specific investment.

Nevertheless, the job losses projected last December for the period September 2009 to March 2010 might be smaller than anticipated earlier. We examine this question with a chart of a current employment forecast below.

One attribute of the Qual VAR approach is that, during periods when the NBER classification is well-established, one can use those classifications to determine the sign of the business cycle index. For recent observations that belong to a period where the eventual NBER classification is not yet clear, the model can be run without imposing a sign and the data can speak regarding the yes/no recession classification. Starting with the June 2009 data, we stopped imposing a negative sign on the business cycle index and let the data determine it. As of the August 2009 data, the first month where the probability that the business cycle index went below 50 percent was August. This result is the basis for our call that the economy was out of recession by August 2009.

One key point of discussion at present is whether the economy faces a danger of sliding back into recession for the second part of a double-dip recession. The business cycle index and its accompanying payroll employment forecasts can help assess the risk of a double-dip recession. The chart of the business cycle index below illustrates that some backsliding in business cycle conditions is projected early in 2010.

The distance from zero indicates the depth of a recession or the strength of an expansion. Source: author's calculations. These macroeconomic forecasts do not constitute a projection of the stock market or of any specific investment.

The history of the business cycle index illustrates the so-called Great Moderation in the U.S. economy after 1984. Until the current recession, the business cycle index stayed within a comparatively narrow range between -0.5 and 1.5 standard deviations from zero after 1984. The depth of the 2008-09 recession poses a strong counterargument to the Great Moderation hypothesis, however. The business cycle index also illustrates how some economic expansions were sufficiently strong and sustained to bring the unemployment rate down to low levels, such as 3.8 percent by April 2000 and 4.4 percent by October 2006.

To see if the projected backsliding in business cycle conditions in early 2010 represents a serious threat of a double-dip recession, we can look at the forecasted recession probabilities for future months. The chart below shows that the recession probabilities do not reach the threshold between 40 and 50 percent where we would call a double-dip recession.

Source: author's calculations. These probabilities are derived from simulations of a Qual VAR model with the specific variables mentioned above.

The current employment forecast shows some promising job gains between October and December 2009 and then some backsliding, with a small negative forecast for March 2010. If this occurs, there will be discussion about the possibility of a double-dip recession, although that is not the scenario projected here. Instead of a double-dip recession, the forecast presented here is one where it takes a long time for the economy to achieve consistent triple-digit job gains, which are not expected until 2011.

Source: St. Louis Fed FRED database for actual data and author's calculations. These forecasts are derived from simulations of a Qual VAR model with the specific variables mentioned above.

Another big name is targeting the ETF industry: Russell Investments has filed for sweeping exemptions with the Securities and Exchange Commission that would allow it to create actively managed as well as index-based ETFs.

The July 2 filing designates Russell Investment Management Company as the adviser to the funds and Russell Financial Services as the distributor. It makes several requests, beyond the basic operation of ETFs, such as allowing funds of funds operated by Russell to buy shares of the ETFs in amounts beyond what is normally allowed under SEC guidelines and allowing ETFs launched by Russell to use the firm’s own indexes.

The filing specifies that the funds could cover domestic stocks, international stocks or fixed income. It also says that the holdings of each fund for the prior day, whether passive or actively managed, will be made available on a daily basis. No individual funds were actually described in the filing.

A subsidiary of Northwestern Mutual, Russell Investments has a total of $136 billion under management, no small sum by any means. Given that the firm already has its own family of well-known indexes (some of which already underlie ETFs from other providers) in addition to operating traditional mutual funds, entry into the ETF arena seems a natural fit.

The field is seeing quite a few newcomers looking to break into ETFs, with Pimco rolling out its first fund and Old Mutual filing for its own funds. With Russell’s involvement in institutional management, there could be a bigger push for wider inclusion of ETFs in 401(k)s.

A 40-APP filing is one of the first filings a fund company must make before it can offer ETFs. Once the exemptions are granted by the SEC, the issuer can then file prospectuses for new funds.

You can read Russell’s 40-APP filing here.

--Contributed by Heather Bell

Oil ETF Grows Too Big?

The enormous growth of the U.S. Oil Fund (NYSE: USO) since the second half of last year has made it difficult for the fund to hide its monthly automatic rollover in front-month contracts, according to this Dow Jones News Service story.

On Friday, it rolled over such a huge number that analysts are blaming it for influencing prices.

You can read the story here.

Dividend Focused ETFs

John Spence of MarketWatch takes a survey of ETFs that focus on dividends on the market.

You can read the story here.

More On Jim Cramer's Record

Considering you might've read on these pages last September Jim Wiandt's blog, "Why Jim Cramer's A Moron," how could we not bring the latest Barron's cover story?

It's titled "Cramer's Star Outshines His Stock Picks."  (Seeking Alpha has an interesting commentary about how this story differs from the magazine's last review of Cramer's record. It also notes that Barron's stock picks for 2008 did even worse. You can read that article here.)

You can read the Barron's story for free (thanks to MarketWatch) here.

This interesting article from BusinessWeek chronicles the work being done by asset managers including Russell Investments and others to develop a new type of 401(k) plan.

But most of the article tracks what's happening at Barclays Global Investors, which is considered among the most aggressive in moving forward with new programs. To make a long story short, these hybrid plans basically resemble target-date retirement funds with fixed deferred-income annuities serving as the bond component.

You can read the story here.

Current business cycle forecasts see a July or August 2009 trough and a jobless recovery until March 2010

by Michael Dueker

In analyzing the current recession, it is useful to be able to predict the trough date and its depth and to compare it with previous recessions. To do so, I use the Qual VAR model (or this link) because it is designed to identify and characterize recessions in real time, based on the incoming macroeconomic data, as well as forecast future business cycle developments. The announcement from the National Bureau of Economic Research on December 1, 2008, of a cyclical peak in December 2007 meant that the recession onset date I forecast earlier was realized, despite the fact that the current recession did not begin with at least two consecutive quarters of negative GDP growth (at least not in the GDP data available to date).

In general, the Qual VAR model espouses Jim Hamilton's view, that recessions correspond to a switching of gears in the economy, rather than simply a loss of speed due to a few randomly missed strokes within a single gear. As Hamilton has noted, if economic cycles do not signify more than the loss of speed, then the amount of speed the economy needs to lose to signify an economic downturn becomes completely arbitrary, as does the meaning of an economic downturn. In other words, the Qual VAR treats recessions as distinct events in the economy, akin to switches between high and low gears. Inferences as to whether the economy is in an expansionary or recessionary state add important perspective to interpretations of GDP numbers, such as the 2.8 percent GDP growth rate in 2008Q2.

One attribute of the Qual VAR approach is that, during periods when the NBER classification is well-established, one can use those classifications to determine the sign of the business cycle index. Until the NBER's announcement on December 1 of a peak, however, the NBER classification of 2008 was not yet certain. Throughout 2008, I was able to run the model without imposing either a positive or negative sign on the index's 2008 values. During this period, I could use the model to infer the probability that a given month pertained to a recession. Throughout 2008, the model's estimates suggested that a recession was underway, although the data for July and August 2008 indicated that the probability of recession had fallen to about 50 percent prior to the failure of Lehman Brothers. After that, the business cycle index began a sharp decline throughout autumn 2008.

The release on December 5 of the November 2008 payroll employment data made the projected path of the recession go deeper than it went in previous iterations of the Qual VAR forecasts. One handy feature of the Qual VAR is that it provides separate forecasts of the end of the formal recession and the date at which employment growth is expected to become positive. Thus the model can project the extent to which we can expect a jobless recovery to follow the formal recession. For example, after the 2001 recession ended in November 2001, negative employment growth continued unabated until October 2002 and payroll employment did not reach its cyclical bottom until August 2003.

The figure below shows the model-implied business cycle index, where its distance from zero indicates either the depth of a recession or the strength of an expansion. The history of the business cycle index illustrates the so-called Great Moderation in the U.S. economy after 1984. Until the current recession, the business cycle index stayed within a comparatively narrow range between -0.5 and 1.5 after 1984. The projected depth of the current recession poses a strong counterargument to the Great Moderation hypothesis.

The distance from zero indicates the depth of a recession or the strength of an expansion. The recession is projected to end in July or August 2009. Source: author's calculations.

Nevertheless, one could argue that the U.S. economy was experiencing a run-of-the-mill recession until the failure of Lehman Brothers, with the business cycle index bouncing around -0.5. After that shock, financial market conditions sent the economy sharply downward. As for a snap-back after the end of the formal recession, the projected path of the business cycle index is not as vertical as one might hope between zero and one in the second half of 2010. In fact, the cumulative area below +0.5 in the current downturn between August 2007 and January 2011 is quite large. Again this event calls into question the permanence of the Great Moderation in the U.S. economy after 1984.

Given that the past two recessions have been followed by jobless recoveries, where employment continues to fall and remain sluggish well after the end of the formal NBER recession, it is interesting to look at the Qual VAR's forecasts of employment growth. The second figure shows that the forecast is for a jobless recovery to follow the NBER recession again, with payroll employment declining until March 2010 and not returning to trend growth until July 2010.

Forecasts for nonfarm payroll employment starting in December 2008 from Qual VAR model. Source: Federal Reserve Bank of St. Louis and author's calculations for out-of-sample forecasts.

The most similar recession to the current one is 1973-75 when the unemployment rate increased about 4-1/2 percentage points in about a year and a half. In the double-dip recession in the early 1980s, the unemployment rate increased by 5 percentage points but this increase took 3-1/2 years. The stock market decline this year also resembles the death by a thousand cuts in 1974, when the U.S. stock market declined by about 30 percent without hitting a particular crash point.

A few details about the model: Here I have focused on a monthly version of the business cycle model that uses nonfarm payroll employment as the measure of economic activity. In addition, the model uses data on core CPI inflation, the spread between the interest rate on one-month commercial paper rate and Treasury bills, the rate spread between corporate and Treasury bonds and the slope of the yield curve. These quality spreads among interest rates are particularly important in the current context where the failure of the investment bank Lehman Brothers led to a severe contraction of lending in financial markets. For example, issuance of three-month commercial paper essentially ceased.

The annual rebalancing of the Russell/Nomura Japanese stock indexes just concluded, resulting in more than 30% turnover rates for each series in the benchmarking family.

The Russell/Nomura Total Value Index had 212 deletions and 176 additions, while the Russell/Nomura Total Growth Index had 270 deletions and 136 additions.

There are Japanese stock exchange-traded funds from Barclays Global Investors' iShares family, Northern Trust's NETS and from WisdomTree Investments.

JPP and JSC are relatively small ETFs in terms of assets. JSC had close to $73 million in assets through last month while JPP had only $13.5 million.

Among all single-country international ETFs this year, those focused on Japan have held up relatively well in terms of performance. JPP was down 32.15% heading into Monday, while JSC had dropped 23.99% so far in 2008, according to Morningstar data.

That may not seem like impressive performance on the surface, but consider that the broad-based iShares MSCI EAFE Index (NYSE: EFA) for developed international markets has slid more than 45% this year.

The Russell/Nomura Prime Index, which is JPP's index, measures the performance of Japan's top 1,000 float-adjusted stocks. This year, 26 companies came into the Prime Index for the first time and its total market capitalization decreased from 201 trillion yen to 200 trillion yen (as of Oct. 15).

The turnover ratio of the index was 1.6%, which is relatively low compared to previous years, the companies said in a statement.

The number of stocks in the Russell/Nomura Small Cap Index, JSC's underlying index, dropped by 76 companies to 1,100. The small-cap index represents the top 85% and bottom 15% of the Russell/Nomura Japan Equity Index, on a market capitalization basis.

The decrease in JSC's index reflected the larger decline in the capitalization of small-cap companies relative to the overall market decrease.