Over multidecade timelines, Wall Street is a bona fide wealth creator. But when looked at over much shorter periods, the directional movements in the iconic Dow Jones Industrial Average (^DJI 1.05%), benchmark S&P 500 (^GSPC 0.43%), and innovation-fueled Nasdaq Composite (^IXIC 0.92%), are difficult to predict.
Truth be told, there is no such thing as a surefire economic datapoint or predictive indicator that can always, with 100% accuracy, alert investors as to the directional movements in the Dow, S&P 500, or Nasdaq Composite in advance. Nevertheless, there are datapoints and predictive tools that have exceptional track records when it comes to correctly forecasting directional movements for the U.S. economy and/or stock market.
One of those tools hasn't been wrong in 64 years, and it provided Wall Street with a sobering outlook this past week.
Image source: Getty Images.
This index offers an ominous outlook for the Dow Jones, S&P 500, and Nasdaq Composite
Every month, the Conference Board, a nonpartisan think tank focused on providing economic insights, releases data on a handful of proprietary predictive indexes. Arguably the most well-known of those is the Conference Board Leading Economic Index (LEI), whose growth rate is measured on a rolling six-month basis.
The LEI is comprised of 10 inputs. Three of these inputs are financial components, such as the interest rate spread between 10-year Treasury bonds and the federal funds rate. The remaining seven components are nonfinancial, such as average consumer expectations for businesses, average weekly initial unemployment insurance claims, and private housing building permits, to name a few.
The purpose of the LEI is to use these 10 inputs to signal "turning points in the business cycle" approximately seven months in advance. While this seven-month lead time hasn't always been spot-on, the LEI certainly has, when given certain parameters.
When back-tested to 1959, there have been numerous instances where year-over-year growth in the LEI has turned modestly negative. By "modest," I'm talking about year-over-year declines in the LEI ranging from 0.1% to 3.9%. However, year-over-year declines of 4% have represented the proverbial line in the sand where the U.S. economy has always, eventually (key word!), fallen into a recession.
Let's make that 16 months in a row! pic.twitter.com/5gIAiCSRfD
-- Longview Economics (@Lvieweconomics) August 17, 2023
This past Thursday, Aug. 17, 2023, the Conference Board released its data from July. The LEI declined by 0.4% on a month-to-month basis, which marked the 16th consecutive month of declines. It's the longest period of consecutive declines in the LEI since the Great Recession.
More importantly, the year-over-year drop in the LEI is more than double the aforementioned arbitrary decline level of 4% where the index has, with 100% accuracy, predicted U.S. recessions for more than six decades.
Although the Conference Board's Coincident Economic Index signals surprisingly strong growth for the U.S. economy in the very short-term, Justyna Zabinska-La Monica, Senior Manager, Business Cycle Indicators, at the Conference Board notes that, "The Conference Board now forecasts a short and shallow recession in the Q4 2023 to Q1 2024 timespan."
Historically speaking, about two-thirds of the S&P 500's drawdowns occur after, not prior to, a U.S. recession being declared. In other words, it signals that 2023's monster rally may be nothing more than a sizable bear market bounce.
Following the money is a recipe for caution
But it's not just the LEI that incents caution from investors. A multitude of money-focused datapoints suggest economic weakness is a probable outcome in the not-too-distant future.
US Commercial Banks Bank Credit data by YCharts.
For example, commercial bank credit is a figure that rises with such consistency over long periods that few economists or investors pay attention to it. Since the U.S. economy grows over time, we expect banks to increase their lending over time to cover the costs associated with taking in deposits.
However, there have been four occasions since the start of 1973 where U.S. commercial bank lending has retraced by at least 1.5% from its record high. The previous three instances all correlated with the benchmark S&P 500 losing around half of its value. The fourth instance has been ongoing since the short-lived regional banking crisis.
Since mid-February, weekly data shows that aggregate bank lending is down by nearly 2%. If commercial banks are getting stingier with their loans, it usually means slower economic growth isn't too far off.
US Net Percentage of Banks Reporting Tightening Standards for C&I Loans to Large and Middle-market Firms data by YCharts. Gray areas denote U.S. recessions.
To add to the above, banks have reported tighter lending standards for commercial and industrial (C&I) loans. C&I loans are usually collateralized short-term loans that businesses from all walks use to fund working capital, major projects, and acquisitions.
Over the past 32 years, the proverbial line in the sand where U.S. recessions take shape is when more than 50% of banks are reporting tightening standards for C&I loans, which is exactly what we've seen in the third quarter. If banks are less willing to lend, it signals concern about the economic outlook for the United States.
Additionally, M2 money supply can be lumped in as a potential ominous warning for Wall Street.
US M2 Money Supply data by YCharts.
The two most-commonly followed money supply metrics are M1 and M2. The former factors in cash and coins in circulation, as well as demand deposits in checking accounts. Meanwhile, the latter takes everything in M1 and adds in savings accounts, money market accounts, and certificates of deposit below $100,000.
M2 has been on a virtually uninterrupted uptrend for the past 153 years, which makes sense given that a growing economy needs more cash and coins in circulation to conduct transactions. However, a 2% or greater drop in year-over-year M2 money supply has served as a warning for investors. The previous four instances where M2 fell 2% or greater between the 1870s and the 1933 resulted in three depressions and a panic.
As of July 2023, M2 was 3.75% below its record high, set in July 2022. Less cash in circulation when core inflation is well above its historic norm looks to be a recipe for a deflationary downturn in the U.S. economy.
Image source: Getty Images.
This numbers game favors long-term optimists
Based on the Conference Board LEI, which has never been wrong, and a slew of money-based metrics, the U.S. economy looks set to weaken in the coming quarters. If accurate, this could lead to equities performing poorly.
But the smartest investors know there's a big difference between recessions and periods of expansion. Although recessions are a normal and inevitable part of the economic cycle, the 12 downturns the U.S. economy has faced since the end of World War II have lasted just two to 18 months. That compares to periods of expansion, which often last for multiple years. For patient, optimistic investors, this is a simple numbers game that continually pays off.
For instance, sell-side consultancy company Yardeni Research has provided data on all corrections for the broad-based S&P 500 dating back to the Great Depression. Since 1950, there have been 39 separate double-digit percentage drops in the S&P 500. Yet with the exception of the 2022 bear market, every previous double-digit decline was eventually put into the back seat by a bull market rally. When given enough time, Wall Street's major indexes have always recouped their short-term losses.
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
Wealth management company Bespoke Investment Group has offered additional evidence that staying the course is a smart move. Beginning in September 1929, Bespoke analyzed how long (in calendar days) the S&P 500 spent in bull and bear markets. Note, Bespoke defines a bull market as a 20% or greater rally following a 20% or greater decline. A bear market is defined as the reciprocal -- a 20% or greater drop following a 20% or greater rally.
What Bespoke found was that the average bear market has lasted just 286 calendar days since September 1929. That's not even 10 full months. By comparison, the average bull market has lasted 1,011 calendar days, or around 2 years and nine months.
It simply pays to be patient and optimistic on Wall Street, no matter what the short-term economic data and predictive tools say.
