Historically speaking, Wall Street is one of the top long-term wealth creators, and the U.S. economy tends to grow over many decades. But when examined on a year-to-year basis, the performance of both the stock market and U.S. economy can be unpredictable.
For instance, the ageless Dow Jones Industrial Average (^DJI 0.69%), broad-based S&P 500 (^GSPC 1.20%), and technology-dependent Nasdaq Composite (^IXIC 1.59%) all entered a bear market in 2022 and closed out the year with their worst performances since 2008.
Image source: Getty Images.
Likewise, warning signs are building that the U.S. economy may not be on the best footing. Even though the U.S. unemployment rate moved to a 54-year low of 3.4% in January 2023, a number of recession-forecasting tools suggest the economy is in trouble.
The following three recession indicators have been flawless at predicting economic downturns for at least 56 years -- and they're all in agreement on what happens next.
1. The Treasury yield curve portends problems ahead
The first surefire recession-predicting tool comes courtesy of the Federal Reserve Bank of New York. The NY Fed's recession probability indicator relies on the difference in yields (i.e., the "spread") between the 10-year and three-month Treasury bond.
Normally, the Treasury bond yield curve slopes up and to the right. In other words, bonds that mature 10, 20, and 30 years from now offer higher yields than Treasury bonds set to mature in three months or two years. The longer your money is tied up, in theory, the higher the yield should be to compensate you.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray zones denote recessions.
Trouble arises for the U.S. economy when the Treasury yield curve flattens and inverts. A yield curve inversion is when short-term bonds have higher yields than longer-maturing Treasury notes. When this happens, it's a pretty clear sign investors are worried about the economic outlook. It's worth noting that while every U.S. recession since World War II has been preceded by a Treasury bond yield curve inversion, not every inversion has been followed by a recession.
The NY Fed's recession probability indicator clearly shows distress, with the spread between the 10-year and three-month bond widening to levels not seen in four decades. As of January 2023, the NY Fed's probability of a U.S. recession within the next 12 months was 57.13%.
Except for October 1966, where recession probability peaked at 41.14% and no recession followed, every other instance (save for the present) where the NY Fed's tool has surpassed 40% for the past 56 years has led to a recession within 12 months.
2. The ISM Manufacturing New Orders Index spells trouble
Last week, I dug into another recession-forecasting tool that hasn't been proven wrong in 70 years: the U.S. ISM Manufacturing New Orders Index, which is a subcomponent of the U.S. ISM Manufacturing Index.
The ISM Manufacturing Index (also known as the Purchasing Managers Index), which is released by the Institute of Supply Management (ISM), surveys more than 400 executives in the industrial sector each month. The responses received from these execs provides data for the five seasonally adjusted components used in the index's calculation: new orders, employment, production, supplier deliveries, and inventories.
US ISM Manufacturing New Orders Index data by YCharts. Gray zones denote recessions.
The ISM Manufacturing Index and all of its subcomponents are based on a scale of 0 to 100, with 50 representing the baseline. Any figure above 50 represents expansion of the index or a subindex, whereas a reading below 50 implies contraction.
As its name suggests, the ISM Manufacturing New Orders Index analyzes new industrial orders. Between the beginning of 1948 and January 2023, the ISM Manufacturing New Orders Index fell below 43.5 on 14 occasions. Except for a steep decline in the early 1950s, a drop below 43.5 has signaled a U.S. recession every single time for seven decades.
In January, the ISM Manufacturing New Orders Index fell to 42.5. Not counting the pandemic-induced recession in 2020, this is the lowest reading since the Great Recession.
3. The Conference Board Leading Economic Index has been flawless predicting recessions
The third recession indicator that's been spot-on when it comes to forecasting U.S. recessions since 1959 (or 64 years ago) is the Conference Board Leading Economic Index (LEI).
The LEI is a predictive tool comprised of 10 inputs that's designed to "anticipate turning points in the business cycle by around seven months," according to the Conference Board. These inputs include financial components, such as the S&P 500 index of stock prices and the interest rate spread, as well as nonfinancial components, like ISM New Orders, average consumer expectations for business conditions, and average weekly hours (manufacturing).
U.S. LEI is measured as a six-month annualized growth rate. Although the LEI can turn negative and provide a warning to those following this indicator, readings often ranging from -0.1% to -3% haven't led to a recession in the months to follow.
The key historic figure for the Conference Board LEI has been a six-month decline of 4% or greater. Anytime we've seen the LEI drop at least 4%, a recession has followed not too long thereafter.
Based on data from the Conference Board, the LEI peaked in February 2022. Though seven months has been the statistical norm for when recessions materialize following a peak, there are multiple instances of 10-to-20-month lags between 1980 and 2010 where the LEI hit its high point and a U.S. recession materialized.
As of December 2022, the LEI was down 4.2% over the six-month period. The writing on the wall is very clear that a recession is likely.
Image source: Getty Images.
Smart investors are putting their money to work
But there's an important point to be made about U.S. recessions that investors should be aware of: They usually don't last very long. Comparatively, economic expansions in the U.S. often last multiple years, if not a decade. This means recessions are an opportunity for patient investors to put their money to work in high-quality stocks at a discount.
For newer investors who haven't been through a true downturn on Wall Street during a recession (i.e., not that two-month swoon during the COVID-19 pandemic), exchange-traded funds (ETFs) can be a smart investment choice. ETFs are basket funds that provide instant diversification or concentration at the click of a button.
Although ETFs do have fees attached (you can find these via the net expense ratio), they're often small. More importantly, ETFs remove the need for individual stock picking, if that's not something you want to tackle.
For those of you who do enjoy owning stakes in individual companies, seeking out dividend stocks can be a genius way to get ahead during a recession. Companies that pay a regular dividend tend to be recurrently profitable and have transparent growth outlooks. Equally important, dividend stocks are usually time tested and have navigated their way through one or more previous economic downturns.
Basic necessity stocks can also be bought to hedge against recession-driven weakness. For example, homeowners and renters are unlikely to change their electricity or water consumption habits during economic booms and busts. This makes the utility sector an intriguing place to go shopping when the winds of recession begin blowing.
The key point being that smart investors are going to continue putting their money to work in a down market. Every double-digit percentage downturn in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite eventually gives way to a bull market rally -- and this time will be no different.
