Over extended periods, there's arguably no greater creator of wealth than Wall Street. Even with inevitable down years, the major stock indexes have delivered higher annualized total returns than bonds, commodities, and housing over the long run.
But when the examined timeframe is shortened to mere months or a couple of years, directional moves in the iconic Dow Jones Industrial Average (^DJI -0.66%), benchmark S&P 500 (^GSPC -0.22%), and growth-driven Nasdaq Composite (^IXIC -0.22%), are impossible to predict with concrete accuracy.
However, this doesn't stop professional and everyday investors from attempting to gain an advantage by following forecasting tools that have historically strong correlations with the broader market.
Image source: Getty Images.
When given a certain set of parameters, one forecasting tool has an as-of-now flawless track record of predicting directional stock market moves dating back to 1959. Though it intimates the potential for a stock market crash to come, there remains a relatively bright outlook for long-term investors.
This unblemished predictive tool is on the verge of making history
While there is no shortage of money-based metrics that are raising eyebrows at the moment, the predictive tool that may be of the greatest concern to Wall Street and the U.S. economy is the Conference Board Leading Economic Index (LEI).
The LEI is a 10-component index that attempts to anticipate turning points in the U.S. business cycle. Three of its components are financial in nature, such as the Conference Board's proprietary Leading Credit Index, while the remaining seven are non-financial and include the ISM Manufacturing New Orders Index, average weekly initial unemployment insurance claims, and average consumer expectations for business conditions, to name a few.
We've now had 19 consecutive monthly contractions in the Conference Board leading index – which is typically what happens just before recessions start...
-- Longview Economics (@Lvieweconomics) November 21, 2023
...yet markets are priced for 'immaculate disinflation'... pic.twitter.com/4mDaRUvBmT
Though the LEI is reported as a monthly figure (as shown above), it's often presented as a six-month growth rate and typically compared to the sequential six-month period, as well as on a year-over-year basis. It's these year-over-year changes that are currently raising warning flags.
When back-tested to 1959, the LEI has had quite a few instances where it's declined by 0.1% to 3.9% on a year-over-year basis. These modest declines typically serve as moments of caution for the U.S. economy.
However, every previous instance of a 4% or greater year-over-year drop in the LEI over the past 64 years has accurately forecast a coming U.S. recession. The LEI is currently lower by close to 8% on a year-over-year basis, which implies economic weakness (i.e., a recession) to come.
While the U.S. economy and stock market aren't tied at the hip, a strong economy is almost always needed for corporate earnings and consumer spending to head higher. Historically, around two-thirds of the S&P 500's total drawdowns have occurred after, not prior to, a recession being officially declared. To be even more succinct, stocks usually perform poorly during U.S. recessions.
Leading Economic Index from @Conferenceboard has fallen on month/month basis for 19 consecutive months ... closing in on streak we saw in early 1970s; other than that period, only comparable time re: length of streak was GFC pic.twitter.com/nzJyfyruny
-- Liz Ann Sonders (@LizAnnSonders) November 21, 2023
Additionally, the 0.8% decline reported in October 2023 by the Conference Board marked the 19th consecutive monthly drop for the LEI. Over the past 64 years, the only two continuous declines for the LEI that lasted longer began in 1973 (22 months) and during the Great Recession in 2007 (24 months). The LEI is on the verge of making dubious history if the current streak continues.
To add to the above, the previous two extended declines in the LEI correlated with the benchmark S&P 500 losing in the neighborhood of half of its value. While this doesn't mean a stock market crash is in any way imminent or guaranteed, historic precedent does suggest it's, at the very least, a possibility.
Image source: Getty Images.
History overwhelmingly favors long-term, optimistic investors
But history is a two-way street. Although there are a handful of economic indicators, metrics, and predictive tools that suggest the Dow Jones, S&P 500, and Nasdaq Composite could head notably lower in the coming months or quarters, history is (as I noted earlier) quite clear about long-term directional moves in the stock market.
For instance, data presented by sell-side consultancy company Yardeni Research shows there have been 39 double-digit percentage declines in the broad-based S&P 500 since the start of 1950. This works out to a double-digit decline, on average, every 1.9 years.
However, something that's just as commonplace as stock market corrections, bear markets, and even stock market crashes, is bull markets and rallies. Dating back more than a century, every notable decline in the Dow, S&P 500, and Nasdaq Composite, with the exception of the 2022 bear market, has been cleared away by a bull market rally. You could rightly say that time has a way of healing all wounds on Wall Street, at least in the context of the major stock indexes.
History also demonstrates the power of optimism over extended periods.
In June, investment analysis company Bespoke Investment Group released data that examined the average length of bull and bear markets in the S&P 500 dating back to the start of the Great Depression in September 1929. Whereas the average bear market has lasted about 9.5 months (286 calendar days), the typical bull market over the past 94 years stuck around for approximately two years and nine months (1,011 calendar days).
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
Looking back even further cements the power of time as an ally for investors.
Every year, analysts at Crestmont Research update a dataset that examines the rolling 20-year total returns, including dividends, of the benchmark S&P 500. Even though the S&P didn't exist until 1923, its components could be found in other major indexes at the time, which allowed researchers to back-test their dataset to 1900. This provided 104 rolling 20-year periods (1919-2022) of total returns data.
What Crestmont's data shows is that all 104 rolling 20-year periods dating back to the start of the 20th century have produced a positive total return. In other words, it hasn't mattered if you, hypothetically, purchased an S&P 500 tracking index near the peak of a bull market or bought during a bear market -- you would have made money either way.
No matter what Wall Street throws investors' way -- even if that's a short-term recession and/or a stock market crash -- patience and optimism are a proven recipe for wealth creation.
