Friday, October 2, 2009

Kamakura gets the Hype Award for their amazing prediction

Kamakura has recently announced that the recession is over. Reuters picked up the story shortly after.

RiskCenter: Kamakura’s President Warren A. Sherman said Thursday, “The index’s continued improvement, especially among high risk credits, is excellent news. It’s now increasingly obvious that the recession is over for the economy as a whole.

Kamakura (a "risk management" technology group) is using their "default probabilities" index to determine the end of the recession. Here is a chart from the firm showing default probabilities for companies that have at least 1% chance of defaulting.

source: RiskCenter

But wait a minute. These are implied default rates - implied from current CDS or bond spreads. One simply assumes some sort of a recovery level in case of default and the default probability is implied from spreads. The index obviously has no predictive power and instead is a function of current risk premium. 2006, 2007 showed the lowest default probability simply because credit was at the highs and spreads were so tight. In fact this is no different than option implied volatility - that's why the VIX chart below has a similar shape.

So Kamakura is using market implied risk premium to forecast recession's end? Why not just use the VIX levels or the CDX spreads to do the same? Or equity prices? The Kamakura index certainly didn't predict the start of the recession, so how can it predict the end? And how is Kamakura, a software company, qualified to call the end of the recession?

The recession may have in fact ended, but the euphoria driven implied default probabilities do not make a GDP forecasting model. All that of course doesn't matter because this press release got them into RiskCenter and on Reuters. Nice way to sell more "risk management" software or get some consulting gigs. For this innovative approach to economic forecasting (and PR), Kamakura gets the good old Hype Award.


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