To the clients and friends of ProfitScore:

Looking at different indicators used to predict the market is always fascinating.  While we at ProfitScore don’t use the Sahm Rule as an indicator, it was interesting enough to share.  The Sahm Rule, named after economist Claudia Sahm, is a simple but effective indicator used to predict the onset of a recession. The rule states that a recession is likely when the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more above its low during the previous 12 months. This signal is designed to detect recessions early, allowing policymakers to respond more promptly.

Accuracy of the Sahm Rule:

  1. Past Recession Predictions: The Sahm Rule has been highly accurate in predicting recessions. Historically, it has successfully identified the start of every U.S. recession since the 1970s. The rule tends to give a timely signal—usually within a few months of the actual onset of a recession—without many false positives.
  2. Timeliness: One of the strengths of the Sahm Rule is its timeliness. It provides a recession signal before the National Bureau of Economic Research (NBER) officially declares a recession, which typically occurs several months after the recession has started.
  3. False Positives: The rule has a low rate of false positives, meaning it rarely signals a recession when one does not occur. However, like any economic indicator, it is not infallible. While the rule has been very reliable in the past, economic conditions and dynamics can change, potentially affecting its future accuracy.
  4. Recent Performance: During the COVID-19 pandemic, the Sahm Rule did signal the recession, but the nature of the pandemic-induced economic contraction was unprecedented, with a rapid and sharp increase in unemployment, followed by a similarly rapid recovery, which was atypical compared to past recessions.

Below is a chart of the real-time Sahm indicator from the Fed website: https://fred.stlouisfed.org/series/SAHMREALTIME

Limitations:

  1. Sensitivity: The rule is sensitive to short-term fluctuations in the unemployment rate, which can be driven by temporary factors rather than a broader economic downturn.
  2. Structural Changes: If the labor market undergoes significant structural changes, the rule might either signal recessions too late or generate false positives.

Overall, the Sahm Rule has historically been a pretty reliable and accurate tool for predicting recessions, particularly for U.S. economic conditions. However, its predictive power depends on the continued relevance of its underlying assumptions in the face of evolving economic dynamics.