Wall Street has taken investors on quite the ride since this decade began. The COVID-19 pandemic led to a breakneck bear market crash in 2020 for the ageless Dow Jones Industrial Average (^DJI +0.73%), widely followed S&P 500 (^GSPC +0.81%), and growth-centered Nasdaq Composite (^IXIC +1.03%). This was followed by a virtually uninhibited rally to all-time highs for the major indexes in 2021, yet another bear market in 2022, and a seemingly uninterrupted rally through the first seven months of the current year.
When the stock market is volatile, new and tenured investors have a tendency to look for economic datapoints, indicators, metrics, or forecasting tools that might give them a clue as to the next directional move in the major indexes.
Although there is no surefire tool capable of accurately predicting directional short-term market movements 100% of the time, there are some datapoints that offer exceptionally strong correlations to directional stock moves. One such forecasting tool, which hasn't been wrong in 57 years, has a crystal-clear take on what's next for the U.S. economy and stock market.
Image source: Getty Images.
This recession-probability indicator has been on-point for more than a half-century
While there are a number of datapoints and metrics that offer strong market-based correlations, it's the Federal Reserve Bank of New York's recession-probability indicator that should have the full attention of Wall Street professionals and everyday investors.
The NY Fed's recession forecasting tool, which has been back-tested to 1959, utilizes the spread (i.e., difference in yield) between the three-month U.S. Treasury bill and 10-year Treasury bond to gauge how likely it is that a U.S. recession will take shape within the next 12 months.
When the U.S. economy is healthy, the Treasury yield curve will slope up and to the right. In other words, bonds that are set to mature in 10 or 30 years will offer higher yields than notes set to mature in a few months or perhaps a year or two. The longer your money is tied up in an interest-bearing investment, the higher the yield should be.
However, when investors are concerned about the near-term outlook for the U.S. economy, it's not uncommon for the Treasury yield curve to invert. During a yield-curve inversion, short-term bills sport higher yields than long-term bonds. Although not every yield-curve inversion has been followed by a U.S. recession, every recession following World War II has been preceded by a yield-curve inversion.
10 Year-3 Month Treasury Yield Spread data by YCharts. Grey areas represent U.S. recessions.
As of July 2023, the inversion between the 10-year bond and three-month T-bill was just shy of a 41-year high. Not surprisingly, the NY Fed's recession forecasting tool indicates a 66.01% chance of a U.S. recession by or before July 2024. That's the third-highest reading (behind only May 2023 and June 2023) since the early 1980s.
To be completely objective, the NY Fed's recession-probability tool isn't perfect. It predicted a strong likelihood of a U.S. recession in October 1966 that, ultimately, never came to fruition. However, every other instance (since 1959) where the probability of a recession within the next 12 months surpassed 32% has, without fail, ended with the U.S. economy contracting.
While it's true that the U.S. economy and stock market are two completely different entities that aren't linked at the hip, stocks have a history of getting clobbered following the initial declaration of a recession by the eight-economist panel at the National Bureau of Economic Research. If this indicator continues to prove accurate, a coming recession would be expected to send the Dow Jones, S&P 500, and Nasdaq Composite notably lower.
The Conference Board's crystal ball also foresees trouble ahead
However, the New York Fed isn't the only entity that has a recession forecasting tool signaling potential trouble to come. The Conference Board's Leading Economic Index (LEI) suggests a U.S. recession is virtually a foregone conclusion.
The LEI a predictive tool made up of 10 inputs that are used to forecast "shifts" in the economic cycle approximately seven months in advance. Three of its inputs are financial in nature, such as its interest rate spread the measures the difference in yield between 10-year Treasury bonds and the federal funds rate. The remaining seven are nonfinancial components, such as the ISM Index of New Orders, average weekly initial unemployment insurance claims, and private housing building permits, to name a few.
The growth or contraction of the LEI is measured on a rolling six-month basis, and is often compared to the previous years' rolling six-month period, as well as the sequential six-month rolling period.
US Conference Board LEI was down 7.8% Y-o-Y in June, a level consistent with a 20% drop in S&P500 EPS. pic.twitter.com/vJWF1Nr5dC
-- Longview Economics (@Lvieweconomics) July 20, 2023
In June 2023, the LEI declined for the 15th consecutive month. This marks only the third time in more than six decades that the LEI has dropped this many months in a row.
More importantly, the LEI was down nearly 8% on a year-over-year basis. When back-tested 64 years, there has never been an instance where the LEI fell by at least 4% from the previous year where a U.S. recession didn't follow.
Could this be the first time the LEI is wrong? Absolutely -- no indicator or predictive tool is perfect. Nevertheless, given certain parameters, the LEI has never incorrectly forecast a U.S. recession. With the LEI down 7.8% on a year-over-year basis in June 2023, it signals the expectation of a U.S. recession in the third quarter of 2023 through the first quarter of 2024, according to Justyna Zabinska-La Monica, Senior Manager, Business Cycle Indicators, at the Conference Board.
Image source: Getty Images.
Recessions are blessings in disguise for long-term investors
On the surface, U.S. recessions aren't much fun. Economic contractions usually lead to poor wage growth and an increase in the unemployment rate. But for patient investors, these periods of instability can be viewed as an opportunity.
While recessions are a normal and inevitable part of the economic cycle, they tend to be short-lived. All 12 U.S. recessions following World War II have lasted just two to 18 months. That compares to periods of economic expansion that, in most cases, have been measured in multiple years. In fact, the expansion leading up to the COVID-19 crash lasted more than a decade. Wall Street disproportionately gives optimists a better chance at growing their wealth.
To add to the above, the stock market spends a considerably longer amount of time moving up than navigating choppy waters. Wealth management firm Bespoke Investment Group recently ran the math on what the average bull market and bear market has looked like for the S&P 500 since September 1929.
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
Using the definition of a 20% rally (following a bear market) or 20% drop-off (following a bull market) in the benchmark index as the respective qualifying factor for a "bull" or "bear" market, Bespoke calculated the length of 27 separate bull and bear markets over 94 years. Whereas the average bear market has lasted 286 calendar days since September 1929, the typical bull market sticks around for 1,011 calendar days, or roughly 3.5 times as long.
Furthermore, investors can pull up a multidecade chart for the Dow Jones Industrial Average, S&P 500, or Nasdaq Composite to see just how powerful time can be as an ally. Even though the major indexes have undergone dozens of corrections since 1950, they've always, eventually, put these downturns in the rearview mirror and marched to new highs. This is the eventual fate of the 2022 bear market, and it's why a forecast recession in either in 2023 or 2024 shouldn't be a concern for long-term investors.
