For more than three years, Wall Street's major stock indexes -- the iconic Dow Jones Industrial Average (^DJI 1.56%), broad-based S&P 500 (^GSPC 1.52%), and innovation-fueled Nasdaq Composite (^IXIC 1.78%) -- have been whipsawed. In 2020 and 2022, the major indexes navigated their way through bear markets. Meanwhile, 2021 and the first eight-plus months of the current year have resembled bull markets.
When uncertainty rules the roost on Wall Street, as it has for years now, investors often turn to history as a guide. Although there isn't an economic datapoint or predictive metric that can, with 100% accuracy, forecast short-term directional moves in the Dow Jones, S&P 500, and Nasdaq Composite, there are indicators with phenomenally strong track records of doing just that.
Last week, one of those leading indicators offered a sobering message for Wall Street and investors.
Image source: Getty Images.
We've only seen this happen three times in 64 years (and it's not great news)
The indicator in question that should rightly be raising some eyebrows is The Conference Board Leading Economic Index (LEI). The Conference Board is a nonpartisan think-tank, and the LEI is a predictive economic indicator comprised of 10 inputs that "anticipates turning points in the business cycle by around seven months."
Seven of the LEI's inputs are nonfinancial, such as average weekly initial unemployment insurance claims, average consumer expectations for business conditions, and private housing building permits, to name a few. Meanwhile, the remaining three inputs are financial and include The Conference Board's proprietary Leading Credit Index, the S&P 500 index of stock prices, and the interest rate spread between 10-year Treasury bonds less the federal funds rate.
The LEI's growth rate is measured on a rolling six-month basis and is frequently compared to the sequential six-month period and comparable six-month period in the previous year.
On Sept. 21, 2023, The Conference Board reported that the August LEI fell 3.8% over the six-month period between February and August. That's more or less comparable with the decline over the sequential six-month stretch (a 3.9% drop between August 2022 and February 2023).
Leading Economic Index (LEI) from @Conferenceboard declined in July, which marked 16th consecutive contraction ... streak that long has only been seen in recessions that started in 1973 and 2007 pic.twitter.com/ThjCW8yQy5
-- Liz Ann Sonders (@LizAnnSonders) August 18, 2023
More importantly, it marked the 17th consecutive monthly decline for the LEI (one more than the post from Charles Schwab chief investment strategist Liz Ann Sonders notes above). When back-tested to 1959, there have only been two instances where the LEI has endured a longer consecutive streak of declines: 1973 and 2007. The decline that began in 1973 lasted 22 months, while the 2007 decline in the LEI halted after 24 months. These two instances also resulted in the S&P 500 losing 48% (1973) and 57% (2007) of its value.
The concern for investors is that the LEI's year-over-year decline strongly signals a coming U.S. recession. While the LEI has had numerous instances since 1959 where it's fallen by 0.1% to 3.9% on a year-over-year basis, a drop of 4% or greater has, historically, always been followed by a U.S. recession. The year-over-year decline in the LEI is currently around 8%.
Although Wall Street and the U.S. economy don't move in tandem, a U.S. recession would be expected to negatively impact corporate earnings, which would almost certainly weigh on equities. Data shows that the benchmark S&P 500 has endured approximately two-thirds of its drawdowns in the one year following the official declaration of a U.S. recession. In simple terms, stocks tend to perform poorly during recessions -- and the LEI is signaling that an economic downturn is very likely.
Image source: Getty Images.
Bear markets can be a blessing for those with a long investment horizon
Admittedly, most economists have been calling for a recession since 2023 began -- and they've, thus far, been wrong. But given the mounting evidence from a 17-month decline in the LEI, historic yield-curve inversion, and rare drop in U.S. M2 money supply, the deck does appear to be stacked against America's economy in the very short term.
However, this is no reason for long-term investors to panic. As much as we might dislike red ink in our portfolios, downturns in the U.S. economy and stock market share one thing in common: they tend to be short-lived.
Since the end of World War II, there have been 12 U.S. recessions. Only three of these 12 recessions have lasted at least 12 months, and none has surpassed 18 months. By comparison, most periods of economic expansion over this time have been measured in multiple years. Even though economic downturns are perfectly normal and unavoidable, they're just minor speed bumps when examined with a wider lens.
It's much of the same when examining the performance of the stock market over long periods. According to data analyzed by wealth management company Bespoke Investment Group, the 27 bear markets it defined since September 1929 have lasted an average of 286 calendar days (about 9.5 months). That compares to the 27 bull markets over the same 94-year stretch, which have lasted an average of 1,011 calendar days -- 3.5 times as long as the average bear market.
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
If investors want to pan out even further, the data becomes even more convincing. With the exception of the 2022 bear market, every single double-digit correction, crash, and bear market in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite, throughout their storied history has, eventually, been put into the backseat. Time has a way of healing all wounds on Wall Street, which is why it's such an important ally for investors.
However, no study drives home the importance of optimism and patience more than Crestmont Research's annually updated dataset. Researchers at Crestmont examined the total returns, including dividends paid, an investor would have netted had they, hypothetically, purchased an S&P 500 tracking index and held that position for 20 years. This dataset was back-tested all the way to 1900, leading to 104 ending years' worth of total returns data (1919-2022).
The great reveal is that all 104 rolling 20-year periods produced a positive total return. Putting your money to work on Wall Street and allowing your investment thesis to play out over 20 years in the S&P 500 (via tracking index) has, thus far, been a foolproof, moneymaking strategy for more than a century.
Whatever may happen in the months to come will likely provide long-term-minded investors with an opportunity to pounce.
