The only certain bet on Wall Street over short periods is uncertainty. Since the start of 2020, investors have watched the iconic Dow Jones Industrial Average (^DJI 0.79%), benchmark S&P 500 (^GSPC 0.72%), and growth-focused Nasdaq Composite (^IXIC 1.03%), oscillate between bull and bear markets.
Although all three major stock indexes have meaningfully bounced off of their 2022 bear market lows, it's no sure thing that the rally continues -- at least based on one top-notching recession-forecasting tool, which is approaching uncharted territory.
Image source: Getty Images.
This recession-predicting tool hasn't been wrong in over 60 years
While there is no shortage of economic datapoints that have uncanny correlations with short-term moves in the Dow Jones, S&P 500, and Nasdaq Composite, the one with perhaps the best forecasting track record is the Conference Board Leading Economic Index (LEI).
The LEI a monthly reported index comprised of 10 inputs, three of which are financial in nature, including the Conference Board's proprietary Leading Credit Index. The remaining seven components are non-financial and include private housing building permits, average weekly initial unemployment insurance claims, and average consumer expectations for business conditions, among other inputs.
The purpose of these 10 elements is to, collectively, help signal peaks and troughs in the economic cycle. More specifically, the LEI "anticipates turning points in the business cycle by around seven months," according to the Conference Board.
The LEI is measured as a six-month growth rate and often compared to the sequential six-month period, as well as the comparable period from the previous year. Whereas modest declines of 0.1% to 3.9% from the prior-year period have served as warnings of economic weakness, declines of 4% or greater in the LEI on a year-over-year basis have always forecast a U.S. recession, when back-tested 64 years.
The September LEI produced a 3.4% decline over the six-month period between March 2023 and September 2023. While this represents a smaller decline than the 4.6% contraction between September 2022 and March 2023, the LEI remains nearly 8% lower on a year-over-year basis. Based on the track record of the LEI, this is a figure that signals a forthcoming recession.
But that's not all.
Leading Economic Index (LEI) from @Conferenceboard has declined for 18 consecutive months, which has only happened in recessions that took place in 1970s and 2007-2009 pic.twitter.com/MawkNTlbA0
-- Liz Ann Sonders (@LizAnnSonders) October 20, 2023
September also marked the 18th consecutive month of LEI declines. Since 1959, there have been only two instances where the LEI has endured a longer consecutive monthly decline: a 22-month drop during the 1973-1975 recession, and a 24-month decline during the financial crisis of 2007-2009. Both of these recessions saw the broad-based S&P 500 lose around half of its value.
Although the LEI is strictly forecasting shifts in the business cycle, recessions are known for adversely impacting equities. Approximately two-thirds of the S&P 500's drawdowns have occurred after, not prior to, an official recession being declared. If the LEI is correct and the U.S. dips into a recession in the not-too-distant future, a drop in corporate earnings, and stocks, would be expected.
More than 100 years of history favors long-term-minded investors
On one hand, the Conference Board LEI has never been wrong forecasting a U.S. recession once the year-over-year drop surpasses 4%. On the other hand, extensive datasets show there's little for long-term-minded investors to worry about, even if the U.S. dips into a recession.
There's no denying that recessions are unpleasant. They typically lead to declining corporate earnings and a higher unemployment rate. But what's important to note about economic downturns is they're relatively short-lived.
Image source: Getty Images.
Since the end of World War II, the U.S. has navigated its way through 12 recessions. Nine of these 12 downturns lasted less than a year, with the remaining three failing to surpass 18 months. By comparison, nearly all expansions lasted multiple years. In fact, the COVID-19 pandemic interrupted a period of expansion that had gone on for more than a decade.
We see a similarly disproportionate timeline between bull and bear markets on Wall Street. In June, wealth management company Bespoke Investment Group comprehensively analyzed 27 separate bull and bear markets for the S&P 500 dating back to September 1929. Note, Bespoke defines a bull market as a 20% or greater rally following a decline of at least 20%. Meanwhile, a bear market is the reciprocal -- a decline of 20% following a rally of at least 20%.
According to Bespoke's calculations, the average S&P 500 bear market has lasted 286 calendar days, which works out to about 9.5 months. Comparatively, the average S&P 500 bull market over the past 94 years has endured 1,011 calendar days, or a little over 3.5 times as long as the typical 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
Bespoke's findings aren't a surprise. Corporate earnings growing in lockstep with the U.S. economy over long periods is what allows equity valuations to expand.
If you're still not convinced that time is investors' greatest ally, the researchers at Crestmont Research can allay your doubts.
Every year, Crestmont updates its dataset that examines the rolling 20-year total returns, including dividends paid, of the S&P 500. Even though the S&P didn't come into existence until 1923, researchers at Crestmont were able to back-test their total returns data to 1900 since the S&P's components could be found in other prominent indexes. This gave Crestmont 104 rolling 20-year periods of data (1919-2022) to work with.
Crestmont's analysis shows that all 104 periods produced a positive total return. Whether a hypothetical investor purchased at the peak of a bull market or happened to pile in during a bear market hasn't mattered. As long as they held their position for 20 years, they would have generated a positive total return, period.
Furthermore, most of these rolling 20-year periods produced sizable returns. Whereas you can count on one hand how many of these 104 ending periods yielded an annualized total return of 5% or below, around 50 rolling 20-year periods produced an annualized return ranging from 9% to 17.1%.
Regardless of what happens with the U.S. economy and stock market in the coming quarters, long-term investors are perfectly positioned for success.
