It's pretty amazing what a difference a year can make on Wall Street. Since this decade began, the iconic Dow Jones Industrial Average (^DJI 0.40%), broad-based S&P 500 (^GSPC 1.02%), and growth-centric Nasdaq Composite (^IXIC 2.02%), have been taken on nothing short of a roller-coaster ride that's changed dramatically with each passing year.
- In 2020, the COVID-19 pandemic crash plunged all three indexes into a bear market in a span of five weeks.
- In 2021, the Dow Jones, S&P 500, and Nasdaq Composite romped to multiple all-time highs.
- Last year, all three major indexes plummeted into a bear market for the second time in as many years.
- This year, all three indexes have bounced meaningfully off their lows and have, by at least one definition, kick-started a new bull market.
While most investors would gladly accept a continued running of the bulls, a new sobering update for Wall Street by American banks could quickly change that tune.
Image source: Getty Images.
Did U.S. banks just spoil the party for Wall Street?
On the surface, things appear to be going fairly well for the U.S. economy. Despite most economists entering 2023 with the notion that the U.S. would enter a recession, the U.S. unemployment rate remains near historic lows, the headline inflation rate, as measured by the Consumer Price Index for All Urban Consumers (CPI-U), is well off of its June 2022 high of 9.1%, and second-quarter U.S. gross domestic product came in stronger than anticipated.
But it's not all about headline figures. A meaningful change at domestic banks suggests a shift in economic activity is forthcoming -- and it could spoil Wall Street's party.
Every quarter, the Board of Governors of the Federal Reserve releases a senior loan officer survey that covers various bank lending practices. Lending is the bread-and-butter that allows banks to cover the expenses associated with taking in deposits (e.g., interest expenses, labor, and so on). The key point being that banks are incented to lend -- especially when interest rates are increasing and they can generate more net-interest income by originating loans.
While there are a number of differing loan types, the one of interest is commercial and industrial loans, which are commonly known as C&I loans. These are typically collateralized, short-term loans that businesses use for working capital, major projects, and acquisitions. When the U.S. economy is healthy and banks aren't too worried about loan delinquencies or losses, they're willing to loosen their lending standards.
US Net Percentage of Banks Reporting Tightening Standards for C&I Loans to Large and Middle-market Firms data by YCharts. Gray areas represent U.S. recessions.
However, when domestic banks believe trouble is on the horizon, or are already dealing with a variety of economic disruptions, they're liable to tighten their lending standards on C&I loans.
During the third quarter, the Senior Loan Officer Opinion Survey showed that more than half (50.8%) of domestic banks are tightening their lending standards for C&I loans to large and middle-market firms. That's up from 46% in the sequential second quarter, and right in line with levels observed during previous U.S. recessions. Since 1990, a reading above 50% has always been followed by, or immediately preceded by, a recession.
If banks aren't willingly lending to businesses like they once were, the expectation would be for a slowdown in hiring and innovation, along with a meaningful drop-off in acquisition activity. In short, it's a recipe for an economic slowdown, if not a full-blown recession.
Historically speaking, around two-thirds of all losses in the major stock indexes occur in the year following the official declaration of a U.S. recession.
Banks aren't the only potential party poopers for the Dow, S&P 500, and Nasdaq
The concern for Wall Street is that tightening lending standards for C&I loans represents just one of a growing list of metrics that points to downside for the U.S. economy and stock market.
US M2 Money Supply data by YCharts.
Take U.S. money supply as a perfect example. M2 money supply, which incorporates the cash bills, coins, and demand deposits in M1, and adds in money market funds, savings accounts, and certificates of deposit below $100,000, has been steadily climbing for 90 years. This isn't a surprise given that a growing economy will require more cash and coins in circulation to conduct transactions.
What's been especially rare are instances where M2 money supply declines by more than a fraction from its all-time high. Since July 2022, M2 has fallen by 3.75%. This is only the fifth time since 1870 that we've witnessed a greater than 2% year-over-year drop in M2.
Statistically speaking, a 3.75% decline in M2 is peanuts compared to the record-breaking 26% year-over-year jump in M2 during the COVID-19 pandemic. The drop we're seeing now could be nothing more than a return to the mean, so to speak.
Then again, the previous four times M2 money supply declined by at least 2% led to three depressions (1870s, 1921, and Great Depression) and one panic (1893). Every prior instance of M2 meaningfully dropping resulted in a deflationary recession and hard times for investors.
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
Another example is the Conference Board's Leading Economic Index (LEI). The LEI is comprised of 10 inputs (three financial and seven nonfinancial) that aim to predict shifts in the U.S. economic cycle by approximately seven months.
While there have been numerous instances over the past 64 years where the LEI has produced small year-over-year declines, the somewhat arbitrary line in the sand has been a year-over-year drop of 4% or greater. Since 1959, a year-over-year drop in the LEI of 4% has a 100% success rate of forecasting a coming recession. In June 2023, the LEI declined for a 15th consecutive month and is down 7.8% from the prior-year period.
Collectively, the Senior Loan Officer Opinion Survey, decline in M2, and meaningful year-over-year drop in the LEI, all imply a coming recession. Historically, the early stages of a recession have boded poorly for the Dow Jones, S&P 500, and Nasdaq Composite.
A long-term mindset can negate short-term economic concerns
Although a number of underlying datapoints and predictive indicators are a potentially ominous warning for Wall Street over the coming months and quarters, patient investors with a long-term mindset have been here before and realize there's nothing to worry about.
Looking back to 1950, there have been 39 instances where the benchmark S&P 500 shed 10% or more of its value. This works out to a double-digit decline, on average, every 1.89 years. Even though Wall Street doesn't adhere to averages, the point here is that corrections are commonplace.
Image source: Getty Images.
What's been just as common is bull market rallies completely wiping away any evidence of stock market corrections and bear market declines. Despite never knowing ahead of time when corrections will occur, how long they'll last, or how steep the drop will ultimately be, history has shown that every decline (save for the 2022 bear market) has eventually been whisked away by a bull market rally. Patience has continually rewarded long-term investors.
To add to the above, optimism is also rewarded. Based on data from wealth management company Bespoke Investment Group, the average length of an S&P 500 bear market since September 1929 is "just" 286 calendar days. That compares to 1,011 calendar days for the average S&P 500 bull market over the same roughly 94-year stretch. It disproportionately pays to be an optimist on Wall Street.
Although directional movements in the short-term can be difficult to predict with any accuracy, history leaves little doubt that "up" is where the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite are headed over a multidecade stretch. Invest accordingly.
