The researchers created an index comprised of four factors and then used the Mahalanobis distance — a measure initially used to analyze human skulls — to determine how current market conditions compare to prior recessions.
“The Mahalanobis distance was originally conceived to measure the statistical similarity of the values of a set of dimensions for a given skull to the average values of those dimensions for a chosen group of skulls,” the researchers explained.
It measures the distance between a point and a certain distribution.
Using this principle, the researchers analyzed four market factors — industrial production, nonfarm payrolls, stock market return and the slope of the yield curve — on a monthly basis. They then measured how the current relationship between the four metrics compares to historical readings.
Looking at data back to 1916, the researchers said that the index was a reliable recession indicator since it rose leading up to every prior recession. They found that when the index topped 70%, the likelihood of a recession in the next six months rose to 70%.
As of November 2019, the reading on the index was 76%.
Of course, a number of economic indicators suggest that the economy is chugging along just fine.