Must the Diffusion Index Lead?

Author(s): Stefan Valavanis

Source: The American Statistician, Vol. 11, No. 4 (Oct., 1957), pp. 12-16
Published by: Taylor & Francis, Ltd. on behalf of the American Statistical Association
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 MUS TE DIFFUSION INDEX LEAD?
STEFAN VALAVANIS

Harvard University

In justifying their use of diffusion indexes for eco- SCORES CONTRIBUTED BY SERIES 1 AND 2
nomic forecasting some investigators have claimed that TO THE DIFFUSION INDEXES
turns in a difJusion index precede turns in the aggregate
of the series from which the diffusion index is computed. Formula A
This opinion is sometimes advanced as a mathematical
Mlonth Scores contributed by Value of the index
theorem holding exactly, and sometimes as a statistical Series 1 Series 2 Simple Cumulated
statement, with a certain probability of being true. 1

As a mathematical theorem the proposition is false. O 0 0.00 0.00

2
Whether it holds true in the statistical sense it is impos- 0 1 0.50 0.50
sible to say, because nowhere do the authors that have 3

put it forth tell us anything explicit about the stochastic 1 0 0.50 1.00
4
properties of the basic time series, from which are de- 1 0 0.50 1.50
rived the aggregate and the diffusion index. 5
0 1 0.50 2.00
Definitions 6
1 1 1.00 3.00
A diffusion index is a number summarizing the be- 7
havior of several time series. There are three main
formulas:
Forinila B
Formula A: The proportion of series expanding from
one period (henceforth "month") to the Month Scores contributed by Value of the index
Series 1 Series 2 Simple Cumulated
next.
1 0 0 0.00 0.00
Formula B: The proportion of series reaching a 2 0 0 0.00 0.00
trough less those reaching a peak. 3 1 -1 0.00 0.00
4 0 0 0.00 0.00
Formula C: The average duration of run, in "months", 5 -1 0 -0.50 -0.50
that is to say, the average number of 6 1 0 0.50 0.00

months the series have been expanding

(scoring +j) or contracting (scoring -) . Forimula C
The diffusion index (any formula) is presented either
Month Scores contributed by Value of the inidex
"simple", as I just defined it, or "cumulated" starting Series 1 Series 2 Simple Cumulated
from some arbitrary point in time.
-1 -1 -1.00 -1.00
Example 2

To fix ideas, I compute all six varieties of the diffusion -2 1 -0.50 -1.50
3
inidex, based on just two componenit series. 1 -1 0.00 -1.50
4
Series 1 Series 2 S: Total 1 & 2
2 -1 0.50 -1.00
Month Value Behavior Value Behavior Value Behavior 5

1 100 100 200 -1 1 0.00 -1.00

6
falls falls falls
1 2 1.50 0.50
2 96 99 195
7
falls rises falls
3 90 trough 102 peak 192 trough
rises falls rises
By convention, for x mouiths' rise (or fa'l1) followed by y
months of constancy we score plus (or minus) x for the duration
4 96 100 196
of months x+1, x+2, . . . x+y.
rises constant rises
5 97 peak 100 197 peak
The question I want to investigate is whether there are
falls rises falls
nathematical or stochastic relationships between the be-
6 95 trough 101 196 trough
rises rises rises havior of indexes A, B, C, on the one hand, and the
7 97 107 204 behavior of the aggregate S on the other.

12 The Aimerican Statistician, October, 1957

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 Milton Lipton, of the National Industrial Conference
Board, who works with Formula C both in its simple and
its cumulated variants, appears to think that there is a
mathematical relationship. The following quotation relates
to comparisons he has made between-
a) total industrial production, and the diffusion index
of its 24 components,
b) wholesale price index, and the diffusion index of
its 15 "major commodity groups",
c) total department store sales, and the diffusion index
of their 12 geographical regions.
The quotation:
"Production, Prices, Department Store Sales: Their
Movements Since the End of the War"
Subtitled:
"Predicted by Average Diffusion Curves . . . Traced
out by Cumulative Diffusion Curves."
On the other hand, Geoffrey Moore, who for the most
part works with Formula A, is quite clear that the re-
lationship is stochastic and not exact. When he states that
"certain types of diffusion index are closely cor-
related with the rates of change in the corresponding
aggregates" 4 he must mean an "empirical" correlation
and not a mathematical necessity. The empirical cor-

"The average-duration-of-run curves show a decided relation is part "substantive", and part "stochastic".
tendency to lead the indexes [i.e. production index, price By "substantive" I mean correlation that is due to

index, sales index] at turning points-a significant prop- economic" interconnections in phasing, sequence, am-

erty of the index itself, since the components are in no plitude, etc., of the basic time series; "stochastic" cor-
sense leading indicators-but their fluctuations are not relation arises by chance, since several combinations of

regular, making identification of cycles uncertain, and values of the basic series can generate a given value of

the amplitudes of their swings are imperfectly correlated the diffusion index or a given value of the sum of the
with the amplitude of the indexes."' series. The stronger the stochastic (or the exact) rela-
tionship, the less can we use the diffusion index as an
This seems to say that the mathematical relationship
indicator of substantive connections between economic
(1) exists but is hard to spot because of short irregular
variables. This is why it is important to know whether
saw-tooth movements in the basic series, and (2) holds
the relationship is exact, or stochastic; and if stochas-
true as far as timing is concerned, but not as far as
tic, how strong. That Moore excludes mathematical ne-
amplitude.
cessity is clear from a later statement in the same place:
In another place 2 Lipton states, again speaking of
"One must not forget that a high correlation is not
Formula C:
the same as an identity."
"To the extent that a diffusion of trends in produc-
tion among the various industries is correlated with ex-
Disproof for Formula A
pansions and contractions in industrial production, a
It is quite easy to disprove the alleged theorem by
positive reading [of Formula C] should reflect an in-
counterexample.
crease in the production index."
This statement is either tautologous or meaningless, but
EXAMPLE OF TWO TURNING POINTS IN THE
does suggest that a mathematical relationship is to be
AGGREGATE NOT PRECEDED BY TURNING
sought. Later on, in the same place, Lipton writes:
POINTS IN THE INDEX
"When an aggregate fluctuates in response to simul-
taneous changes in its components, the diffusion index Series 1 Series 2 S: Sum of 1 & 2 Diffusion

will have sharply delineated features, but these will Value Behavior Index

exactly mirror the aggregate."X 3 100 100 200

falls 0.50
The last two quotations are considerably cloudier than
96 101 197
the first. Unless "simultaneous changes" means "changes falls 0.50
in the same direction" how can the index exactly mirror 90 102 192 trough
rises 0.50
the aggregate ? Some clarification comes from the
96 100 196
caption of the chart given in pages 228-9: rises 0.50
97 100 197 peak
falls 0.50
1 Milton Lipton, "Cyclical Diffusion: A New Tool for Study-
95 101 196
ing Business Trends," The Conference Board Business Record,
vol. XI, No. 6 (June 1954), p. 232.

2 Milton Lipton, Cyclical Diffusion: A New Tool For Busi- 3 Ibid., p. 35.
ness Analysis, Technical Paper Number Five, National Industrial 4 Geoffrey H. Moore, "Diffusion Indexes: A Comment", The
Conference Board, New York, 1956, p. 10. Ame7ican Statistician, Vol. 9, No. 4 (Oct. 1955), p. 13.

13

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EXAMPLE OF TURNING POINTS IN THE INDEX either (1) by chance, or (2) out of the economic logic
NOT FOLLOWED BY TURNING POINTS IN of the component series, their relation in time, the mean-
THE AGGREGATE ing of their aggregate in economic terms, and the like.
Diffusion Index Values of the Series Sum of the It is vain to expect the diffusion index to forecast turn-
Value Behavior #1 #2 #3 #4 four series ing points in the sum for mathematical reasons only, as
100 100 100 100 400 the mathematical properties of the index are insufficient.
0.50
rises 99 98 101 101 399 Disproof for Formula B
0.75 peak
falls 94 99 102 103 398
There is no need to set up a counter-example, since
0.50 Formula B is connected with Formula A. The relation-
falls 95 100 102 100 397
ship is
0.25
falls 96 98 102 100 396 E(t) E(t-l)-P(t-l) +T(t-1)
0.00 trough
which can be paraphrased as follows: The number
rises 95 98 102 100 395
0.25 E(t) of series expanding in January, equals the number
96 98 100 100 394
E(t-1) expanding in December, less the number of series
It is clear that the index can be insensitive to swings
reaching peaks in December, plus the number reaching
in the sum, and the other way around. What then, if troughs in December. Rearranging the formula and di-
any, is the mathematical relationship between formula A
viding by N (the total number of series in the index)
and the sum S? It is a very "weak" relationship, in fact we obtain
a one-to-many, or a many-to-many correspondence, be-
E (t) -E (t-l1) T (t-1 )-P (t-l1)
tween A and S', the rate of change in the sum S:
N N
(1) A== 0 implies S'?0
The left-hand side of this equation is the month-to-month
(2) 0<A< 1.00 implies nothing at all about S'
(3) A_1.00 implies S'>O change in Formula A, while the right-hand side is
Formula B itself. Therefore, A'=B, and whatever I
(4) S'>0 implies 0<A<?1.00, the converse of (1)
just showed above to be true (or false) for the relation-
(5) S',0 implies 0<A<1.00, the converse of (3). ship of Formula A index to the sum S of the series,
If the index is between 0 and 1.00 anything can be
is also true (or false) for :B, or Formula B cumulated.
happening to the sum, as the first example shows. If
There is a weak mathematical relationship between 1B
the sum is expanding, the index can have any value at
and S, (and hence between B and S) since this is all
all except zero, because at least one component must be
there is between A and S.
expanding.
More specifically, when B reaches 1.00, all compo-
If the index is 1.00 then the sum is expanding, be-
nent series reach troughs, and hence S must be on the
cause 100 percent of the components are expanding. If
increase; similarly, when B reaches -1.00, S must be
the sum is stationary or declining, the index can have
decreasing. As long as B remains between these limits,
any value including 0 and up to but not including 1.00.
nothing can be said about S, no matter how B behaves,
This is so because if the index were 1.00 then the sum
and conversely, nothing can be said about B, no matter
could do nothing but increase since all the components
how S behaves.
are increasing. On the other hand, it is possible for
99.99 . . . per cent of the components to be expanding,
Disproof for Formula C
The following counter-example shows that the diffusion
but as long as the one remaining component falls dras-
index according to Formula C can be completely insen-
tically enough, this is sufficient to keep the sum station-
sitive to swings in the sum S:
ary or to cause it to fall.
Index
If the index is 0, then the sum cannot rise since every Series 1 Series 2 S: Sum of 1 & 2 Formula C
component is either stationary or falling. Value Score Value Score Value Behavior Average
There is nothing special about a diffusion index equal length of
run (months)
to 0.50. With 50 percent of the components rising,
100 100 200
their sum can be rising, falling, constant, reaching a 1 -1 falls 0
peak, or a trough. And conversely, if the sum is reach- 101 97 198
ing a turning point, nothing in particular can be in- 2 -2 constant 0
102 96 198
ferred about the index's being at the 50 percent level. 3 -3 falls 0
The mathematical relationship is clearly a weak one. 104 90 194 trough
Now, if it turns out in fact that a zero diffusion index -1 1 rises 0
99 110 209
has coincided with severe contraction in such-and-such
-2 2 constant 0
an aggregate, or that a 50 percent diffusion index has 97 112 209
preceded a turning point in the aggregate, and so on, -3 3 rises 0
96 116 212 pea'k
these properties are additional ones arising not out of
1 -1 falls 0
the logic of the index in the mathematical sense, but 107 87 194

14 The American Statistician, October, 1957

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 The rise (or fall) of the sum can be the result of Formula A (percent expanding)
small rises in all the components; then C will be small
If Si > 0, then score ai = 1
and positive (small and negative). If the sum increases
for the reason that the increase in one component over- if S, 0, then score ai = 0.
whelms the decrease in the other components, then C N
will be negative. A (t) =-E ai (t).
N M=
The following counter-example shows that swings in
the diffusion index need not herald changes in the sum: Formula B (percent reaching turns)

If S" >0, then score b= 1

Series 1 Series 2 Series 3 Sum Index Formula C
if S1 < 0, then score bi=-I.
Value Score Value Score Value Score Value Behavior
100 100 100 300 1N
1 -1 1 0.33 B(t)= NZEbi(t).
=i
101 98 101 300 rises
2 1 -1 0.67
102 99 99 300 rises
Formula C (average duration of run)
3 -1 1 1.00 peak
104 96 100 300 falls Here the score ci(t) depends on the value of ci(t-1),
-1 1 2 0.67 because this is what is meant by a "run". The following
102 97 101 300 falls table shows all the combinations:
-2 2 -1 -0.33 trough
100 100 100 300 rises when: S'(t-1) >0 S'(t-1) =0 S(t-1) <0

1 -1 1 0.33 and:

101 98 101 300 S'(t) >0 ci(t) =ci(t -1) +1 ci(t) =1

S (t) =0 ci(t) =ci(t-1) ci(t) =Ci(t-1) ci(t) =ci(t-1)

Formula C is even more weakly related to the sum S
SIMt <0 ci(t) =- * i(t) =ci(t-1) -1
than are Formulas A and B. Indeed, no mathematical
relationships can be exhibited for it, as was done in *j**) and ci(t-2) =0,.. .ci(t-k) =0, ci(t-k-1) >0 ci(t-k--1) <0

the case of Formula A.5 * then ...................... ci(t) =ci(t -1) +1 ci(t) = +1
** then ...................... ci(t)=-1 ci(t)=ci(t-1)-1
The stochastic relations between a diffusion index and
1N
the sum of the component series can be developed, in
C (t) = Eci(t).
principle, easily enough. However, the formula for actual
computation of the probability that the index predicts
the sum is so intricate, even in the simplest of cases, that
not even a guess as to its order of magnitude can be The stochastic relation between diffusion index and
ventured. sum can be expressed by
Let Si(t) stand for the value at time t of the i-th series, P( IS"(t)-81 <0 given that IA" (t-p) -? <0),
of which there are N. Let the sum at time t be represented that is to say, the probability that turns in A lead turns
N in S by p months, or by the expression
by S(t). Then S(t) = Si(t). S'(t) >0 means the sum
i=1 P(IS"(t)-8 I<O given that JA"(t-p) -0.501(<E),
is rising, S'(t) <0 means it is falling, S"(t) >0 that it is that is to say, the probability that values of the index
at a trough, S"(t) <0 that it is at a peak. Similar sym- close to the 50 percent mark precede by p months turns
bols will be used for the behavior of A(t), B(t), C(t), in the sum S. Similar expressions for Formula B and
the diffusion indexes by the three formulas. Let ai(t), C diffusion indexes do not need to be shown.
bi(t), ci(t) stand, respectively, for the "score" contrib-
The above probabilities can be ascertained if we derive
uted by the i-th series to each index type. Then the fol-
the joint distributions
lowing expressions define the construction of the index.
f (S"(t) A"(t-p) ) f (S"(t) A(t-p) )
(The time indicator (t) is omitted where it is obvious.
and similarly for B and C-type diffusion indexes. To
Also continuity is assumed, because it is easier to work
derive the distributions we need some kind of an assump-
with derivatives than with differences. This simplification
tion about the stochastic nature of the basic time series
does not affect what I want to show in any significant
Sl, S2. . . . SN. For example let us assume that
way, and the translation back to finite differences is easy.)
Si (t) =mi+Misin(Ti+ eit) +ui (t)
'This statement is not watertight. If the components of the where mi, Mi, Ti, ei are constants expressing the trend,
diffusion index are just two, then some wea'k restrictions come cyclical amplitude, cyclical phase and cyclical frequency
into force. But it is completely useless to develop and prove them,
of the i-th series and u I(t) is a term representing its
since nobody constructs diffusion indexes from just two com-
ponents. irregularity.

15

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 It is hard to simplify this assumption without throwing
out essential elements of the problem. We could disregard
trend (set mi-0). We cannot abstract from amplitude
because the sum S= Si depends on it critically. We
can specify that ui (t) is a random variable, normally
distributed, with finite variance, zero mean, and that
there is no correlation between ui(t) and ui(t') nor
between ui and uj. Roughly, these restrictions express
that the irregular is a true irregular arising in each
month and in each time series out of a multitude of small
44causes uncorrelated with each other. Even with these
simplifications, the joint distributions we are seeking de-
pend in a very complex way on relations between the
Mi, Ti and ei on the one hand and the lead of p months,
COMMENT ON "MUST THE DIFFUSION INDEX LEAD?"
There are two sentences in Mr. Valavanis' statement
with which I would take issue. At the outset he says
"Whether [the lead in the diffusion index] holds true
in the statistical sense it is impossible to say, because
nowhere do the authors that have put it forth tell us any-
thing explicit about the stochastic properties of the
basic time series, from which both the aggregate and
the diffusion index are derived." And at the end, "Un-
less these authors perform such a test [to determine 'how
much of the lead is a genuine empirical finding about
business cycle behavior and how much merely inheres
in the manner of defining the diffusion index'], their
findings based on the diffusion index cannot be taken
seriously."
I do not know how much of what has been published
about diffusion indexes Mr. Valavanis has read (beyond
the two articles he cites), or whether he has made any
attempt to find out what is still in unpublished form,
but I do know that these two sentences are incredible in
the face of what has been published and even more
incredible in the face of the materials that still repose
in the files of the National Bureau of Economic Research
(but are available to anyone whose research purposes
can be taken seriously!) I have not made a precise
count, but a rough guess is that charts or data for more
than a hundred diffusion indexes have appeared in
print, and we have several hundred more in our files.
In not a single one of these, so far as I can recall, is
there the slightest doubt about the diffusion index'
tendency to lead the corresponding aggregates (if any).
They have been computed in forms that are not pre-
cisely the same as any of Mr. Valavanis' three types (or
16 The American Statistician, October, 1957
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which is alleged for the diffusion index, on the other
hand.
It should be noted that the complexity arises for two
distinct reasons: (1) the characteristics of the time series
are complex, and (2) the definition of the diffusion index
contains discontinuities.
In these circumstances I cannot, by intuition, tell what
the probability is that the diffusion index should lead
the sum by such and such a number of months. There-
fore, I cannot tell how much of the lead observed by
Lipton and Moore is a genuine empirical finding about
business cycle behavior and how much merely inheres
in the manner of defining the diffusion index. Unless
these authors perform such a test, their findings based on
the diffusion index cannot be taken seriously.
GEOFFREY H. MOORE
National Bureau of Economic Research
two types, since B is the first difference of A), as well
as in those same forms. The finding, therefore, holds
for a wide variety of types of economic data, of geo-
graphic coverage, and of time periods. And it seems
to be largely impervious to the method of defining the
diffusion index.
I say "largely impervious" because, as I pointed out
in the article cited by Mr. Valavanis, Formula C (aver-
age duration of run) does characteristically yield a
diffusion index that lags behind one computed by
Formula A (percent expanding), for the reasons indi-
cated in the article. Just as the lead of diffusion in-
dexes over aggregates, as Mr. Valavanis rightly demon-
strates, is not a mathematical necessity, so the lag be-
tween C and A is not either, since examples can be
constructed where it does not happen. Yet it has hap-
pened often enough, and the reasons are clear enough,
so that I for one believe that it "holds true in the sta-
tistical sense" and should be "taken seriously."
Like MVIr. Valavanis, I have quite definite views on when
empirical findings are to be taken seriously, but they are
apparently not the same as his. He says, in effect, "Tell
me something about the stochastic properties of your
series, and I will tell you whether your diffusion index
is something we should be interested in." At the same
time, however, he says that "the actual computation of
the probability that the index predicts the sum is so
intricate, even in the simplest of cases, that not evTen a
guess as to its order of magnitude can be ventured."
Even if I believed the first statement, I would be dis-
couraged by the second. Besides, economic time series
and their relationships are notoriously not simple.