Investing on Wall Street over the past two years has been nothing short of an adventure. In 2021, the iconic Dow Jones Industrial Average (^DJI +0.02%), broad-based S&P 500 (^GSPC +0.84%), and technology-dependent Nasdaq Composite (^IXIC +1.71%) zoomed to new all-time highs. Then, in 2022, all three indexes plunged into a bear market, with the Nasdaq Composite ending the year lower by a whopping 33%!
Although stock market corrections and bear markets are the price of admission investors pay for their chance to take part in one of the world's greatest long-term wealth creators, increased volatility and uncertainty can still be quite unnerving. The current bear market has investors asking one simple question: "When will it end?"
Image source: Getty Images.
While there's no indicator or metric that can concretely and accurately predict when stock market downturns will occur, how long they'll last, or how steep their declines will be, there are indicators that have a knack for calling stock market bottoms over long periods.
One monthly indicator has had a near-flawless track record of signaling an all-clear for investors since the Great Depression, and it has a very clear message for where stocks are headed next.
This monthly indicator has an uncanny track record of calling bear market bottoms
For months, I've provided glimpses of where stocks might head next based on select valuation-based metrics and recession-probability indicators. The next indicator to examine is released monthly and has correctly signaled more than a half-dozen bear market bottoms following recessionary lows dating back to 1929. I'm talking about the U.S. unemployment rate.
Although it's not a perfect indicator, the U.S. unemployment rate has a pretty good track record of alerting investors to a U.S. recession. It's pretty common for the unemployment rate to meaningfully rise when the U.S. economy is faltering.
But what's particularly noteworthy about the U.S. unemployment rate is its uncanny ability to signal bear market bottoms when accompanied by a spike.
Historically, unemployment typically spikes before the market bottoms.
-- David Marlin (@Marlin_Capital) April 5, 2023
Peak Unemployment is one of the best "all-clear" signals for stocks coming out of a Bear Market. $SPY $QQQ $DJIA pic.twitter.com/YCMStTbiq1
According to research provided by Bank of America's Research Investment Committee and shared on social media platform Twitter by David Marlin, CEO of Marlin Capital, the U.S. unemployment rate tends to spike higher and peak following a big low in the stock market. Bank of America notes that, with the exception of the recessionary bear market in 1962, the unemployment rate peaks, on average, about four months after the broader market hits its bear market lows.
BofA's forecast is for the U.S. unemployment rate to peak at 4.8% during the second quarter of 2024. If we make the assumption that the historic average (four months) holds true, the Dow, S&P 500, and Nasdaq would be expected to find their bottom late in the fourth quarter of this year, or perhaps early in 2024.
Multiple recession-probability indicators offer a cautionary tale
Though the U.S. unemployment rate has been a near-flawless indicator for the past 93 years in terms of calling recessionary bear market bottoms, we'd still need the U.S. economy to enter a recession for this indicator to have any bearing. According to the Federal Reserve and numerous recession-probability indicators, the U.S. economy shifting into reverse is looking increasingly likely.
A little over a week ago, the release of the Federal Open Market Committee's meeting minutes from March revealed an expectation that the U.S. economy would enter a "mild recession" later this year. But you don't have to take the Fed's word for it. A handful of probability indicators have been warning of a possible recession for months.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray areas denote U.S. recessions.
For example, the Federal Reserve Bank of New York analyzes the spread (difference in yield) between the three-month and 10-year Treasury bond to determine the probability of a U.S. recession over the next 12 months. With the exception of October 1966, the NY Fed's recession-probability tool hasn't been wrong (dating back to the late 1950s) when the probability of a recession surpasses 32%. As of March 2023, there was a 57.77% likelihood of a U.S. recession over the next 12 months.
Likewise, the Conference Board Leading Economic Index (LEI) is sounding a warning. The LEI takes 10 economic inputs into account and is reported as a six-month annualized growth rate. Since 1959, anytime the LEI has declined by 4% or more, the U.S. economy has, not long thereafter, fallen into a recession. In December, the LEI came in at a reading of -4.2%.
New industrial orders offer an ominous sign as well. The U.S. ISM Manufacturing New Orders Index measures new industrial orders and is reported on a scale of 0 to 100, with 50 representing a neutral baseline. A figure above 50 corresponds with growing industrial orders, while a number below 50 signals contraction. Over the past 70 years, a monthly figure below 43.5 on the U.S. ISM Manufacturing New Orders Index has signaled a coming recession. In January 2023, the reading was 42.5.
Multiple probability indicators, and even the Fed, suggest a recession is likely. Should that happen, the U.S. unemployment rate could serve as a guide that gives investors a confident green light.
Image source: Getty Images.
Long-term investors always have a green light
Although the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have historically struggled after recessions are declared, knowing your investing horizon is far more important than trying to guess when Wall Street will bottom.
If you're only looking a few months into the future, no indicator or metric has a particularly rock-solid record of predicting where stocks will head next. But if your investing timeline stretches multiple years, if not decades, the probability of making money goes way up, regardless of when you put your money to work.
For instance, data from sell-side consultancy firm Yardeni Research shows there have been 39 double-digit percentage declines in the S&P 500 since the beginning of 1950. That's about one, on average, every 1.87 years. However, every one of these downturns, save for the current bear market, was eventually put into the rearview mirror by a bull market rally. Effectively, every sizable downturn in the Dow, S&P 500, and Nasdaq has been a buying opportunity for patient investors.
Something else to consider is the length of U.S. recessions after World War II. Of the 12 recessions declared by the eight-economist panel of the National Bureau of Economic Research over the past 77 years, they've all lasted just two to 18 months. By comparison, periods of economic growth are typically measured in years (note the plural). Though the U.S. economy and Wall Street aren't linked at the hip in the short run, higher corporate earnings associated with an expanding U.S. economy does lead to market value appreciation over time.
Furthermore, long-term investors have been winners no matter when they put their money to work. Market analytics company Crestmont Research examined how much an investor would have made, including dividends paid, if they, hypothetically, purchased an S&P 500 tracking index and held that position for 20 years.
In total, Crestmont examined 104 separate rolling 20-year periods, beginning in 1900. Crestmont's data showed that all 104 ending years (1919-2022) would have produced a positive total return. Regardless of whether the stock market is hitting a new high or is crumbling under short-term uncertainty, historic data conclusively shows that long-term investors are smart for putting their money to work.
