For much of the past year, Wall Street has been climbing a wall of worry. Everything from inflation hitting a 40-year high of 9.1% in June, to the Federal Reserve raising interest rates at the fastest pace in four decades, has rattled the nerves of investors and fueled a bear market for the iconic Dow Jones Industrial Average (^DJI +0.48%), benchmark S&P 500 (^GSPC +0.72%), and growth-dependent Nasdaq Composite (^IXIC +1.16%).
But among the countless headwinds stocks are contending with, none is arguably scarier than the dreaded "r" word: recession.
Image source: Getty Images.
Even though recessions are a perfectly normal part of the economic cycle, the short-term unpleasantries associated with economic downturns, such as weaker corporate earnings and a higher unemployment rate, tend to worry investors. It's why so many people keep asking, "Is a U.S. recession imminent?"
Although there's no concrete answer to that question, there are two recession indicators that have flawless track records of calling/predicting recessions in the U.S. over the past 55 years. Here's what they have to say about our chances of a recession taking shape in the months and quarters to come.
The Treasury bond yield curve tells an interesting tale
Among the vast sea of economic indicators to choose from, the Treasury bond yield curve is the most commonly referenced tool to determine the likelihood of a recession taking shape in the United States.
Normally, the Treasury yield curve slopes up and to the right. This means bonds with longer-dated maturities of 10 and 30 years have higher yields than Treasury bonds maturing in, say, three months or two years. Since your money would be tied up for a longer time frame, you should, in theory, be compensated more for longer-dated maturities.
Prior to U.S. recessions, the yield curve flattens out and inverts. This is to say that short-term Treasury bonds sport higher yields than longer-dated maturities. When this happens, it's a clear indication that investors are concerned about the near-term economic outlook.
Here's the interesting thing: While every single U.S. recession since World War II has been preceded by a Treasury bond yield curve inversion, not every yield curve inversion has been followed by a recession. In other words, a yield curve inversion doesn't guarantee a recession will occur within a year, but it tends to be a pretty good indicator.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray zones denote recessions.
The Federal Reserve Bank of New York closely monitors the yield spread between the 10-year Treasury note and the three-month bond to calculate the probability of the U.S. entering a recession within the following 12 months. When this spread inverts, the probability of a recession tends to climb.
Since the beginning of 1959, the probability of a U.S. recession taking place within 12 months has surpassed 40% on only eight occasions. In 1966, a peak recession probability of 41.14% didn't lead to a recession. However, every time this yield-curve-based recession indicator has crossed above 40% since 1966, it's correctly forecast a U.S. recession within 12 months.
In December 2022, the Federal Reserve Bank of New York's recession indicator hit a probability of 47.31%. It's the highest reading in 41 years, and it clearly indicates that a recession is likely to occur in 2023.
The economy may be running "smoother" than you realize
While the NY Fed's indicator is screaming that a recession is increasingly likely this year, another recession indicator with an exceptional track record of calling economic downturns isn't so convinced.
Backdating to 1967, the Smoothed U.S. Recession Probabilities tool has been successfully used to interpret economic data and determine the likelihood of a recession. While the actual monthly calculation of the Smoothed Recession Probability is complicated -- it uses the dynamic-factor Markov-switching model -- the four variables that go into the calculation are straightforward:
- Nonfarm payroll employment
- Index of industrial production
- Real personal income excluding transfer payments
- Real manufacturing and trade sales
Anytime new data is available for all four of these variables (i.e., once monthly), the Smoothed Recession Probability can be calculated.
US Recession Probability data by YCharts. Gray zones denote recessions.
According to economist Jeremy Piger, who helped develop this recession-forecasting tool, a reading above 80% for three consecutive months is a reliable indicator of a new recession. Over the past 55 years, anytime the Smoothed U.S. Recession Probabilities surpassed 32%, a recession has either occurred very shortly thereafter, or (in hindsight) was in the very early stages of taking shape.
The most recent reading (November 2022) from the Smoothed U.S. Recession Probabilities tool was (drum roll)...just 1.16%. Excluding the coronavirus recession, which lasted just two months, 1.16% is the highest reading since October 2019, but well below any level that would be concerning from a recession standpoint.
With the U.S. unemployment rate of 3.5% tied for its lowest level in nearly 54 years, the takeaway would be that a recession isn't in the cards -- at least according to this highly successful prediction tool.
Image source: Getty Images.
Yes, you can still make smart investments during periods of uncertainty
For those of you hoping for a definitive answer of whether or not the U.S. will enter a recession in 2023, you won't get it with these flawless recession-predicting tools at odds with each other. But this doesn't mean you need to stay on the sideline as an investor. There are plenty of smart ways to put your money to work, even during periods of heighted uncertainty.
Regardless of whether or not the U.S. dips into a recession, buying dividend stocks has been a highly successful investment strategy for decades. Companies that pay a dividend tend to be profitable and time-tested. In other words, you're not going to have to worry about the survival of businesses that pay a regular dividend or grow their dividend annually.
As I recently opined, buying stakes in businesses that provide a basic necessity good or service can be a genius way to invest when Wall Street is on edge. For example, no matter how poorly the U.S. economy performs, homeowners aren't going to cancel their trash collection services. What's more, waste collection providers often act as a monopoly or duopoly, which leaves homeowners with few options. This is how a company like Waste Management has been able to deliver for its shareholders in virtually any economic environment.
Uncertain times can also provide the perfect opportunity to buy an index fund. For instance, even though the S&P 500 has undergone 39 separate double-digit percentage declines since the beginning of 1950, the previous 38 drops were all, eventually, erased by a bull market rally. Big declines have also been erased over time in the Dow Jones Industrial Average and Nasdaq Composite.
Furthermore, time has proved a far more important ally to investors than timing. According to a report from Crestmont Research, which examined the rolling 20-year total returns, including dividends, of the S&P 500, if you bought an S&P 500 tracking index at any point since 1900 and held on to that position for 20 years, you made money.
No matter which camp you fall into -- recession or ongoing expansion -- there are smart ways you can be putting your money to work right now.
