A recession is a significant decline in economic activity spread across the economy, lasting more than a few months. It is visible in industrial production, employment, real income, and other measures of economic activity. A recession generally occurs when there is a widespread drop in spending (an adverse demand shock). This may be caused by an external event such as a financial crisis, an increase in interest rates, a period of high oil prices, or a natural disaster. Alternatively, it may be caused by a more internal event such as a burst of technological innovation or a central bank raising interest rates to slow an overheating economy.
There exist indicators that can be used to aid in predicting a recession. A common one is the yield curve, which is a graph of the yields on bonds of different maturities. An inverted yield curve (where short-term yields are higher than long-term yields) is often seen as a predictor of a recession.
Reference [1] proposed a novel, so-called media recession indicator (MRI) to predict a recession. Basically, the authors measured the frequency with which the word “recession” appeared in financial and economic newspapers and used it as a sentiment indicator to predict a recession. They found out,
… The indicators are based on articles in the Financial Times and the Wall Street Journal, and use different ways of weighting articles that include the key word “recession.” The constructed indicators outperform predictor variables that are well established in the literature. We view this textual-based analysis as complementary to more traditional approaches in predicting business cycles and the stock market. We believe our findings can be useful for central banks and investors interested in business cycles and investment management.
In short, the proposed media recession indicator has predictive power and an investment strategy based on it outperformed Buy and Hold.
Using their research results, the authors concluded that there is value in reading financial news. We note, however, that in order to be able to extract alpha from financial news, one has to use advanced analytical techniques such as natural language processing. This technique is not available to regular investors.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Baz, Salim and Cathcart, Lara and Michaelides, Alexander, What is the Value of Financial News? (2022). https://ssrn.com/abstract=4251414
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