Over very long periods, Wall Street has proved to be a virtually surefire moneymaker. But over weeks, months, or even a couple of years, directional moves in the iconic Dow Jones Industrial Average (^DJI +0.10%), benchmark S&P 500 (^GSPC +0.25%), and growth-oriented Nasdaq Composite (^IXIC +0.47%) are practically impossible to predict with any accuracy.
Since the beginning of the decade, we've watched the Dow, S&P 500, and Nasdaq Composite plunge into two separate bear markets (2020 and 2022), as well as surge to record highs (2021). In 2023, Wall Street is, once again, set to make records -- but of the dubious variety.
Image source: Getty Images.
September 12 will mark an ominous date for the stock market and U.S. economy
The figure that's set to come into focus exactly two weeks from today, on Sept. 12, 2023, has to do with the Treasury yield curve.
The yield curve is a chart that depicts the yields of Treasury bonds based on their maturity. Normally, the yield curve slopes up and to the right. This is to say that long-dated bonds that mature in 10 or 30 years will have higher yields than bills that mature in three months or one year. Logically, the longer your money is tied up, the higher the yield should be.
However, an inverted yield curve has more often than not spelled trouble for the U.S. economy. When the yield curve inverts, short-term bills sport higher yields than long-term Treasury bonds. It's a signal that investors see the U.S. outlook deteriorating. Although not every yield-curve inversion leads to a U.S. recession, every U.S. recession following World War II has been preceded by a yield-curve inversion.
Since 1962, there have been five periods where the yield curve remained inverted for at least 129 trading days. We're currently experiencing one of those periods right now, as shown in the chart shared by Bespoke Investment Group.
We're now 11 trading days from breaking the record for the lengthiest yield curve inversion (10yr/3mth) of the last 60+ years. What kind of impact will this have on the economy?https://t.co/Sj8awm9Uw5 pic.twitter.com/e9KbQBXBRp
-- Bespoke (@bespokeinvest) August 26, 2023
As of today, Aug. 29, the 10-year bond and three-month bill have been inverted for 201 trading days. That's the third-longest streak dating back more than 60 years. But with the 10-year/three-month yield-curve inversion still at a sizable 1.36%, Sept. 12 is set to mark the 210th day of inversion, which would signal the longest period of yield-curve inversion in history.
Though a yield-curve inversion in no way guarantees a U.S. recession, each of the previous inversions that lasted at least 129 trading days were eventually followed by an economic downturn. Based on history, the likelihood of an economic slowdown adversely impacting the stock market and U.S. economy remains high.
To add, history also shows that the S&P 500 has racked up around two-thirds of its losses in the year following the declaration of an official recession. In simpler terms, stocks usually perform quite poorly in the quarters immediately after a U.S. recession becomes official.
Another leading economic indicator spells trouble, too
However, the inverted yield curve represents just one of many predictive tools that's currently waving a warning flag for Wall Street. The highly respected Conference Board Leading Economic Index (LEI) has been a flawless predictive tool for 64 years -- and it's currently signaling trouble on the horizon.
The LEI is made up of 10 components. Seven of these components are nonfinancial, such as the U.S. ISM Manufacturing New Orders Index, while the remaining three are financial in nature, such as the interest-rate spread between the 10-year bond less the federal funds rate.
The LEI is reported as a six-month growth rate and compared to both the sequential six-month period as well as the comparable year-ago growth period.
Let's make that 16 months in a row! pic.twitter.com/5gIAiCSRfD
-- Longview Economics (@Lvieweconomics) August 17, 2023
July marked the 16th consecutive monthly decline for the LEI, which is the third-longest streak on record, dating back to 1959.
Historically speaking, the LEI has had periods in the past where it's produced modest year-over-year declines ranging from 0.1% to 3.9%. These are viewed as moments of caution that may lead to shifts in the economic cycle.
Where things become problematic for the U.S. economy is when the LEI declines by 4% or more on a year-over-year basis. When back-tested to 1959, every decline in the LEI of at least 4% has involved the U.S. eventually dipping into a recession. The current year-over-year drop in the LEI is practically double this historical line-in-the-sand figure of a 4% decline. In other words, the LEI is very clearly signaling that a U.S. recession is expected in the not-too-distant future.
With the Dow Jones, S&P 500, and Nasdaq Composite making a habit of setting their bear-market lows after, not prior to, a recession being declared, the historic takeaway would be that equities are headed lower.
Image source: Getty Images.
Short-term worries are of little concern to long-term investors
The (presumably) longest yield-curve inversion on record, coupled with a seemingly damning forecast from the LEI, squarely puts investors on notice that corporate earnings and the U.S. economy are likely to weaken in the months and quarters to come. But for long-term investors, this near-term outlook represents nothing more than a minor bump in the road.
Let's face the facts: U.S. recessions and stock market corrections are perfectly normal and inevitable. However, they're also short-lived.
Since the end of World War II, there have been 12 official U.S. recessions. These one-dozen downturns have all lasted between two and 18 months. By comparison, almost every period of expansion for the U.S. economy post-World War II has been measured in multiple years. The U.S. economy spends considerably more time expanding than contracting.
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
It's the same story for Wall Street. A few months back, Bespoke examined the average length of bull and bear markets in the S&P 500 dating back to September 1929. Bespoke defined a bull market as a 20% (or greater) rally following a 20% (or greater) decline, with bear markets being the reciprocal (i.e., a 20%+ decline following a 20%+ rally). In total, 27 bull markets and 27 bear markets were identified over 94 years.
What Bespoke found was that the average bear market since September 1929 has lasted 286 calendar days, or close to 9.5 months. By comparison, the typical bull market over the past 94 years has lasted 1,011 calendar days, or about two years and nine months. The average bull market sticks around 3.5 times longer than the typical bear market.
If investors were to simply focus on this long-term numbers game, they'd avoid the hassles of trying to time virtually impossible-to-predict downturns in the stock market. More importantly, they'd be positioned perfectly to take advantage of the long-term growth in corporate earnings that's fueled by a growing U.S. and global economy.
