The stock market is a phenomenal wealth creator, if you give it time. However, the movement of equities can be far less predictable over shorter periods.
Last year, the ageless Dow Jones Industrial Average (^DJI 0.96%), widely followed S&P 500 (^GSPC 1.51%), and growth-driven Nasdaq Composite (^IXIC 2.01%), all fell into a bear market and respectively lost 9%, 19%, and 33% of their value by years' end. It marked the worst performance for this trio since 2008.
Despite the long-term outperformance of equities, down years of this magnitude rightly have investors -- especially new investors -- wondering what's next for stocks. The answer to that question may be found in one of Wall Street's most-trusted indicators.
Image source: Getty Images.
This forecasting tool hasn't been wrong since 1966
Before I go any further, let me offer the usual disclaimer: There is no such thing as a foolproof indicator or metric. If there was an indicator that accurately predicted when stock market downturns would begin, how long they'd last, and how steep the decline would be, we'd all be using it. What we do have are indicators that offer a highly successful track record that can make our lives, as investors, easier.
The indicator that's been captivating the attention of everyday and professional investors alike for more than six decades is the Federal Reserve Bank of New York's recession probability tool. This indicator uses the spread (difference in yields) between the three-month and 10-year Treasury bonds to forecast how likely it is that a U.S. recession will materialize over the coming 12 months.
Normally, the yield curve is sloped up and to the right, with bonds maturing many years down the line having higher yields than bonds scheduled to mature sooner. This is what we typically see in a healthy economy.
However, when economic trouble crops up, the yield curve has a tendency to invert. In other words, short-term bonds sport higher yields than long-term bonds. A yield-curve inversion doesn't guarantee the U.S. will fall into a recession; but it is worth noting that every recession after World War II has been preceded by a yield-curve inversion.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray areas denote U.S. recessions.
According to the newest update from the NY Fed's recession-probability indicator, there's a 68.22% chance the U.S. will enter a recession over the next 12 months. That's the highest probability of a recession occurring in the next 12 months in 41 years. Not coincidentally, we're also witnessing the largest yield-curve inversion between the three-month and 10-year note in more than four decades.
Since 1959, there have been eight instances where the NY Fed's recession-forecasting tool has exceeded a 40% probability of an economic downturn. With the exception of October 1966, every other previous instance of a reading above 40% has resulted in the U.S. economy dipping into a recession. That's 57 years (and counting) without a miss.
The reason recessions matter is because no bear market has bottomed after World War II prior to the official declaration of a recession by the eight-economist panel of the National Bureau of Economic Research. The very clear message from the NY Fed's recession-probability tool is that the Dow Jones, S&P 500, and Nasdaq Composite may not have seen their bear market lows just yet.
Additional signs of caution abound
Keep in mind that the NY Fed's recession-probability tool is just one of a handful of indicators that signals potential trouble to come for Wall Street.
For example, U.S. money supply has been doing something truly historic on both sides of the aisle. M2 money supply, which takes into account everything in M1 (cash bills, coins, and traveler's checks) and adds money market funds, savings accounts, and certificates of deposit (CD) below $100,000, surged a record-high 26% year-over-year during the pandemic. As of March 2023, M2 money supply had declined 4.1% year-over-year, which marks its largest drop in 90 years.
WARNING: the Money Supply is officially contracting. 📉
-- Nick Gerli (@nickgerli1) March 8, 2023
This has only happened 4 previous times in last 150 years.
Each time a Depression with double-digit unemployment rates followed. 😬 pic.twitter.com/j3FE532oac
Although it's possible the decline in M2 is completely benign given how much the U.S. money supply had expanded during the COVID-19 pandemic, the precedent for M2 declines of at least 2% isn't rosy. The four previous times we witnessed drops of at least 2% in M2 led to three recessions and a panic. Admittedly, two of these events occurred prior to the creation of the Federal Reserve, and the other two happened around a century ago. Nevertheless, declining money supply has been an ominous sign in the past.
Another indicator worth keeping a close eye on is bank lending among all U.S. commercial banks. With few exceptions, the total amount of loans and leases outstanding from commercial banks has continued to climb. There are, however, four instances where bank lending retraced by at least 1.5% since the start of 1973. The three previous instances all saw the S&P 500 lose around half of its value. The fourth instance of a 1.5% or greater decline has occurred within the past few weeks.
Even the Federal Reserve has sounded a warning. When the meeting minutes were released from the Federal Open Market Committee's March meeting, they contained an outlook that a "mild recession" was forecast for "later this year."
To reiterate, no forecasting tool is perfect. But historically speaking, stocks have endured the bulk of their bear market losses after, not prior to, a recession being declared.
Image source: Getty Images.
Wall Street has a habit of rewarding patience
While none of these indicators or forecasts paints a particularly bright picture for the stock market in the short-term, it's important to note that economic downturns and bear markets usually don't last very long. The 12 recessions that have occurred after World War II lasted for between two and 18 months.
Furthermore, Wall Street has an undeniable track record when it comes to rewarding the patient. Looking back to the start of 1950, there have been 39 separate double-digit percentage declines in the S&P 500. Excluding the 2022 bear market, all 38 previous downturns in the S&P 500, no matter how steep, were eventually put into the back seat by a bull market rally. This is why recessionary bear markets can hardly be recognized on long-term charts of the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.
Best of all, being an optimist just tends to be more profitable, and a study looking back more than 100 years proves it!
Market analytics company Crestmont Research analyzed what an investor would have made had they, hypothetically, purchased an S&P 500 tracking index and (key point!) held that position for 20 years. Crestmont back-tested its dataset to 1900, which meant every ending year between 1919 and 2022 was examined.
Including dividends paid, all 104 ending years produced a positive total return. It literally didn't matter when you put your money to work on Wall Street. As long as you held that position in an S&P 500 tracking index for 20 years after your purchase, you generated a positive total return. While there are no true guarantees on Wall Street, a dataset that's 104-for-104 is quite compelling.
Though it's possible the next couple of months or quarters could be turbulent for stocks, the future for equities remains as bright as ever.
