Pardon the cliché, but the only guarantee for Wall Street in the short term is that there are no guarantees. For more than three years, the iconic Dow Jones Industrial Average (^DJI 0.28%), widely followed S&P 500 (^GSPC 0.45%), and growth-powered Nasdaq Composite (^IXIC 0.33%), have swung back and forth between bull and bear markets.
When volatility picks up, it's only natural for investors to want an edge in knowing where the stock market will head next. While there aren't any economic indicators or predictive tools that can forecast the future with 100% accuracy, there are a small handful of metrics and forecasting tools that have pretty impressive track records of calling directional moves in the three major stock indexes.
One such forecasting tool hasn't been wrong in nearly six decades, and it paints a very clear picture of what's next for stocks.
Image source: Getty Images.
It's been 57 years since this forecasting tool made an incorrect call
Despite a number of economic datapoints offering historic correlations with directional moves on Wall Street, few forecasting tools have been as successful as the Federal Reserve Bank of New York's recession prediction tool.
The NY Fed relies on the spread (difference in yield) between the 10-year Treasury bond and three-month Treasury bill to determine the probability of a U.S. recession taking place within the next 12 months. Although the U.S. economy and stock market aren't linked at the hip, throughout history, stocks have struggled mightily following the official declaration of a recession. Approximately two-thirds of the S&P 500's drawdowns have occurred after, not prior to, a recession being declared. It's this link that makes the NY Fed's recession forecasting tool so meaningful to Wall Street and investors.
Most of the time, the Treasury yield curve slopes up and to the right. By this, I mean longer-dated Treasury bonds that mature 10 or 30 years from now will have higher yields than bills set to mature in three months or one year from now. If your money is tied up for a longer period, you should be rewarded with a higher yield.
At the moment, the Treasury yield curve is inverted. This is to say that short-term bills sport higher yields than long-term Treasury bonds. Yield-curve inversions are typically a sign that investors are concerned about near-term economic growth prospects.
U.S. Recession Probability data by YCharts. Gray areas denote U.S. recessions.
More importantly, yield-curve inversions have served as a precursor to U.S. recessions. Although not every yield-curve inversion is followed by a recession, all 12 recessions following World War II have been preceded by a yield-curve inversion. In other words, the ingredients are in place for a recession to happen.
As of the latest data release, the NY Fed's probability tool is forecasting a 56.16% chance of a U.S. recession by September 2024. Though the probability of a recession within the next 12 months has actually declined for four consecutive months, this reading still represents the highest likelihood of a recession in more than four decades.
The caveat, of course, is that no forecasting tool is going to be perfect. During the fourth quarter of 1966, the NY Fed's recession probability tool surpassed 40%, but no downturn in the U.S. economy ever materialized. Since this point, any time the NY Fed's forecasting tool has surpassed a 32% probability of a recession within 12 months, it hasn't been wrong.
Based on the 10-year/three-month Treasury spread, there's a heightened likelihood of a U.S. recession, which would more than likely weigh heavily on the Dow Jones, S&P 500, and Nasdaq Composite.
Image source: Getty Images.
Everything depends on investors' perspective
Considering how well the S&P 500 and Nasdaq Composite have performed through the first nine months and change of 2023, a forecast that pretty clearly anticipates a U.S. recession may not have been on your Bingo card. But even if weaker economic growth and a continuation of the 2022 bear market are in the cards for Wall Street, a little perspective can change everything.
As much as investors might dislike recessions, they're a perfectly normal and inevitable part of the economic cycle. Something else recessions are is short-lived. Nine of the 12 U.S. recessions following World War II lasted less than a year, while none have surpassed 18 months in length. That compares to multiple multi-year expansions over the same timeline. In short, there are two sides to this coin, but each side looks very different.
This same comparison can be applied to Wall Street. According to a comprehensive analysis from Bespoke Investment Group that covered 27 bear markets and 27 bull markets in the S&P 500 since September 1929, the average bear market has lasted just 286 calendar days, or about 9.5 months.
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
On the other hand, the typical bull market has endured 1,011 calendar days, or roughly 3.5 times as long as the average bear market. Statistically speaking, it's always been wise to be an optimist, no matter what the short-term predictive indicators might suggest.
Looking even further back provides additional reasons for long-term investors to breathe a sigh of relief.
Every year, market analytics company Crestmont Research updates its extensive dataset that examines the rolling 20-year total returns, including dividends paid, of the benchmark S&P 500. Since the S&P's components could be found in other major stock indexes prior to its creation in 1923, researchers at Crestmont were able to back-test their dataset to 1900. This provided 104 rolling 20-year periods of total returns data (1919 through 2022).
What Crestmont's dataset shows is that if an investor had, hypothetically, purchased the S&P 500 (or in this instance, an S&P 500 tracking index) and held that position for 20 years, they would have generated a positive total return every single time -- 104 out of 104.
What's more, they didn't just squeak by with menial gains. Whereas the number of rolling 20-year periods that ended with an annualized return of 3% to 5% can be counted on a single hand, more than 50 rolling 20-year periods resulted in an annualized total return of between 9% and 17.1%. Patient investors with a long-term mindset often ran circles around the prevailing inflation rate and generated significant real-money returns.
While the ability to time the market would be great, it's perspective, optimism, and patience that's the winning formula for investors.
