When examined over multiple decades, Wall Street's three major stock indexes -- the Dow Jones Industrial Average (^DJI 0.26%), S&P 500 (^GSPC 0.61%), and Nasdaq Composite (^IXIC 0.93%) -- have been nothing short of rock-solid moneymakers. However, their performance over shorter periods can be no more predictable than flipping a coin.
After all three major indexes hit record highs in 2021, the Dow, S&P 500, and Nasdaq followed this phenomenal year up by plunging into a bear market in 2022. Wild swings in equities often leave investors wondering what's next for Wall Street.
Although there isn't an economic indicator or metric that can concretely predict where the major indexes will head with 100% accuracy, there are indicators, metrics, and probability tools with exceptional track records that may give investors who follow them an edge.
Historically speaking, one leading economic indicator paints a very clear picture of which direction the Dow Jones, S&P 500, and Nasdaq Composite are headed next.
Image source: Getty Images.
This leading economic indicator hasn't been wrong since 1959
While there is no shortage of economic datapoints for investors to examine, the Conference Board Leading Economic Index (LEI) stands head and shoulders above most other predictive economic tools.
The Conference Board LEI is comprised of 10 inputs, three of which are financial in nature, such as the stock prices of the S&P 500 and Leading Credit Index. The remaining seven are nonfinancial inputs, including average weekly initial unemployment claims, average weekly manufacturing hours, new private housing building permits, and the ISM New Orders Index, to name a few.
The LEI is reported as a six-month growth rate that can be easily compared to the six-month growth rate in the previous year. According to the Conference Board, "the LEI is a predictive variable that anticipates (or "leads") turning points in the business cycle by around seven months." The Conference Board has back-tested its leading economic index back to 1959.
Though there have been numerous instances over the past 64 years where the Conference Board LEI has declined ever-so-slightly, the somewhat arbitrary figure that's spelled trouble for the U.S. economy is a drop of at least 4%. There hasn't been a single instance since 1959 where the LEI has dropped 4% or more where a U.S. recession hasn't taken shape.
May marked 14 consecutive monthly contractions for Leading Economic Index (LEI) from @Conferenceboard ... a streak only seen in recessions that started in 1973 and 2007 pic.twitter.com/i8eDnBiwPa
-- Liz Ann Sonders (@LizAnnSonders) June 23, 2023
Last week, it was reported that the LEI declined by 0.7% in May 2023 and 4.3% between November 2022 and May 2023. This marked the 14th consecutive monthly decline for the LEI -- the third-longest streak of consecutive monthly declines since 1959 -- and puts the predictive index well beyond the arbitrary line-in-the-sand level where a U.S. recession would be expected.
Although the U.S. economy and stock market aren't tied at the hip, history has shown that equities perform quite poorly in the months that follow the official declaration of a U.S. recession. Therefore, the Conference Board LEI forecasting a recession would imply that Wall Street may not have seen its 2022 bear market lows just yet.
The bulls would like a word...
The Conference Board LEI is far from the only probability tool or economic datapoint signaling the potential for trouble. The Federal Reserve Bank of New York's recession-probability tool is at its highest level in 42 years. Meanwhile, cardboard box usage is down significantly, U.S. commercial banks are tightening their lending standards, and M2 money supply is falling for the first time in 90 years.
Despite this veritable laundry list of potentially worrisome economic data, the bulls would like a word.
By one definition, a bull market begins when an index rallies more than 20% above its bear market low. The benchmark S&P 500 and growth-focused Nasdaq Composite have both met this requisite. What's of interest is how these indexes perform once the bull is officially back.
This won't make the perma🐻, M2, and yield curve inversion crowds very happy, but oh well.
-- Ryan Detrick, CMT (@RyanDetrick) June 4, 2023
Once stocks are >20% off bear lows (currently 19.7% above Oct '22 lows) did you know a yr later stocks have never been lower?
Up 28.2% on avg and 6 mo returns are solid as well.
🐂🎯 pic.twitter.com/3SJ6nC9xWN
According to analysis from Ryan Detrick, the chief market strategist at Carson Group, and Carson Investment Research, once the S&P 500 officially enters a new bull market -- the 20% off bear market lows definition -- it's never been lower one year later.
Detrick's dataset shows that the S&P 500 has gained an average of 28.2% in the 12 months after officially hitting a "new" bull market. Similar to the LEI, this dataset hasn't been wrong in 67 years. It means either the LEI could be facing its first incorrect prediction in its storied history, or the running of the bulls on Wall Street is a bit premature.
Adding fuel to the fire is the historically low U.S. unemployment rate. Though a lower labor participation rate helps to partially explain why the U.S. unemployment rate is near half-century lows, more than a year of better-than-expected nonfarm payrolls data suggests the U.S. economy remains on solid footing.
Image source: Getty Images.
Time is undefeated on Wall Street
If I were to throw a dart and make an educated guess as to where stocks are headed six months from now, I'd be inclined to side with the LEI and a host of other economic indicators that suggest additional downside is likely in the Dow Jones, S&P 500, and Nasdaq Composite. But to build significant wealth on Wall Street, there's no better play than being a long-term optimist.
In the coming quarters, we're going to find out whether the bulls or bears have firmly taken hold over the short term. But over the long run, it's crystal clear that the bulls are in charge. We know this because every stock market correction and bear market throughout history, save for the 2022 bear market, was eventually whisked away by a bull market rally.
Don't get me wrong, there are plenty of things investors are never going to be able to forecast ahead of time. We're never going to know with any certainty when stock market downturns will begin, how long they'll last, or how much the Dow, S&P 500, and Nasdaq Composite will decline. But the long-term data is crystal clear that these indexes eventually march to new all-time highs. That's why it pays to be a long-term optimist.
It's official. A new bull market is confirmed.
-- Bespoke (@bespokeinvest) June 8, 2023
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
To add to the above, wealth management firm Bespoke Investment Group recently published its findings on the average length and return of bull and bear markets since 1929. Note, Bespoke's definition of a bull market is a 20%+ rally that was preceded by a 20% decline, whereas a bear market is defined as a 20%+ drop preceded by a 20%+ rally. This somewhat rigid definition means Bespoke will recognize sizable bear market rallies as "new" bull markets.
According to Bespoke Investment Group, there have been 27 separate bull and bear markets over the last 94 years. Whereas the average bear market has lasted just 282 calendar days and resulted in a decline of 35.1% for the S&P 500, the typical bull market has gone on for 1,011 calendar days and averaged a gain of 114.4%!
The takeaway is simple: If you buy index funds, or high-quality stocks, with intent of holding over long periods, history suggests you shouldn't have any trouble building wealth on Wall Street.
