William Kinlaw, Mark Kritzman, and David Turkington have a head for business indexes — and a theory that traces its past to a human skull, which they say can predict a recession more accurately than any living head with a brain can.
The MIT and State Street researchers have created a new index of the business cycle, named the KKT Index, which is based on a once-forgotten statistic created in 1927 to analyze resemblances in human skulls. The so-called Mahalanobis distance was rediscovered 20 years ago and applied to measure turbulence in the financial markets, and has since been used for other applications, such as diagnosing diseases and detecting anomalies in self-driving vehicles.
While the Mahalanobis distance was originally intended to determine if a set of dimensions for a skull was more plausibly associated with one group versus another, the index uses it to determine if the values for a set of economic variables are more closely associated with the values that prevailed during past recessions or periods of robust growth.
So instead of inputting skull measurements, the KKT Index uses economic data. The index applies economic data to the principles of the Mahalanobis distance — which measures a distance between a point and a distribution — to measure the similarity of a set of economic variables to past episodes of recession and robust growth. The economic data include industrial production, non-farm payrolls, stock market returns, and slope of the yield curve from January 1916 to November 2019.
As of November, the value of the KKT index was 76%, which means it estimated a 76% chance of a recession within the proceeding six months. To put that in perspective, the researchers say that the unconditional likelihood of a recession within any six-month period is only 17%. State Street said that as of January, the index was still above 70%, although it didn’t provide an exact percentage.
“An index level of 76% does not necessarily mean that the economy is currently in recession,” the researchers wrote in their paper, A New Index of the Business Cycle. “Rather we should interpret it as an indication of the potential for the economy to enter recession in the foreseeable future.”
The researchers say their index is more effective than the Conference Board’s indexes of “leading, coincident, and lagging indicators,” which they say tend to coincide with recessions rather than anticipate them like the KKT Index does.
To demonstrate their point, they say that, historically, when the KKT Index exceeded 50%, a recession occurred within six months 54% of the time. When it exceeded 60%, a recession hit within six months 61% of the time, and when it was above 70% a recession came exactly 70% of the time. When it topped 80%, recession occurred 77% of the time, and when it rose above 90%, a recession came 91% of the time.
“As a single index, it conveys information about the path of the business cycle,” they wrote. “Unlike the Conference Board Index of Coincident Indicators, our index gives an independent assessment of the state of the economy because it is constructed from variables that are different than those used by the NBER [National Bureau of Economic Research] to identify recessions.”
They also argue that the KKT Index is more objective than the NBER’s identification of recessions because it is strictly data driven and therefore free of bias. Additionally, they say it gives a more objective assessment of the business cycle than the Conference Board Indexes because it is expressed in units of statistical likelihood.
“The KKT Index rises leading up to every recession so that the combination of its trajectory and level provides a reliable indicator of the likelihood of recession,” the paper said. “As of late 2019, the Conference Board’s Index of Leading Indicators shows a significant discrepancy with the KKT Index. Whereas the KKT Index has spiked recently, the Conference Board’s Index of Leading Indicators has remained flat.”
Kinlaw is a senior managing director at State Street Associates; Kritzman is CEO of Windham Capital Management and a senior lecturer at MIT’s Sloan School of Management; and Turkington is a senior managing director at State Street.