Create own Recession Indicator using Mixture Models


Broadly speaking, we can classify financial markets conditions into two categories: Bull and Bear. The first is a “todo bien” market, tranquil and generally upward sloping. The second describes a market with a downturn trend, usually more volatile. It is thought that those bull\bear terms originate from the way those animals supposedly attack. Bull thrusts its horns up while a bear swipe its paws down. At any given moment, we can only guess the state in which we are in, there is no way of telling really; simply because those two states don’t have a uniformly exact definitions. So basically we never actually observe a membership of an observation. In this post we are going to use (finite) mixture models to try and assign daily equity returns to their bull\bear subgroups. It is essentially an unsupervised clustering exercise. We will create our own recession indicator to help us quantify if the equity market is contracting or not. We use minimal inputs, nothing but equity return data. Starting with a short description of Finite Mixture Models and moving on to give a hands-on practical example.