This Bond Market Alarm Has Predicted Every Recession Since 1969. Here's What It Says Happens Next in the Stock Market.

The stock market had a great year in 2023. The benchmark S&P 500 (^GSPC 1.02%) soared 24%, the blue-chip Dow Jones Industrial Average (DJINDICES: ^DJI) climbed almost 12%, and the technology-heavy Nasdaq Composite (NASDAQINDEX: ^IXIC) skyrocketed 43%. Those gains were fueled in part by stronger-than-expected economic growth.

What made that performance surprising was that countless pundits were expecting a recession, citing elevated inflation and rising interest rates as headwinds to spending. But that recession never happened. In fact, the U.S. economy expanded 2.5% last year, topping the 10-year average of 2.3%, according to the U.S. Bureau of Economic Analysis. But the risk of recession has not disappeared.

Analysts at JPMorgan Chase believe spending could falter this year as the full impact of higher interest rates percolates through the economy. As evidence, they point to rising delinquencies on consumer credit and signs of financial stress across younger households. The bond market supports that concern. Specifically, the Treasury yield curve has predicted past recessions with remarkable accuracy, and it's currently sounding an alarm.

Here's what investors should know.

The bond market is sounding a recession alarm

U.S. Treasury bonds are debt securities that pay a predetermined interest rate based on their maturity date, which can range from one month to 30 years. Normally, long-term bonds pay more than short-term bonds, meaning the Treasury yield curve slopes up and to the right. But under certain circumstances, the yield curve can become inverted, meaning short-term bonds pay more than long-term bonds.

Specifically, investors often move money to long-term Treasuries when they are concerned about a recession. Such bonds are desirable under those circumstances because they offer risk-free returns over an extended time period regardless of the economic environment. Rising demand drives prices higher and yields lower, such that long-term Treasuries can wind up paying less than short-term Treasuries.

In that context, one section of the yield curve is particularly noteworthy. The 10-year and 3-month Treasury yields have inverted before every recession since 1969, with zero false positives. In other words, that bond market indicator has been a perfect recession forecasting tool for more than 50 years.

The table below lists every relevant yield curve inversion and recession since 1969. It also shows how much time elapsed between the two events.

Data source: Federal Reserve Bank of New York, National Bureau of Economic Research. The table shows how much time elapsed between past yield curve inversions (10-year and 3-month Treasuries) and the subsequent recessions.

As shown above, a recession has followed within 16 months of every yield curve inversion between the 10-year and 3-month Treasuries since 1969. That statistic is noteworthy, because the relevant portion of the yield curve is inverted today, and the inversion started 14 months ago in November 2022. In other words, the bond market says the U.S. economy will slip into a recession within two months.

As a caveat, no forecasting tool is perfect no matter how good its track record. For instance, the 10-year and 3-month Treasury yields inverted in January 1966, but no recession followed. The current inversion could be another false positive. But investors should know what to expect in the event of an economic downturn.

The stock market has fallen precipitously during past recessions

In simple terms, the National Bureau of Economic Research defines a recession as a "significant decline in economic activity that is spread across the economy and lasts more than a few months." Such events have negative implications for corporate revenues and earnings, so the stock market tends to decline sharply during recessions.

The table below details the peak decline in the S&P 500 during every recession since 1969.

Data source: Truist Advisory Services.

As shown above, the S&P 500 declined by an average of 34.5% during recessions since 1969. For context, the S&P 500 is currently half a percentage point below its record high, leaving implied downside of 34% if the economy does slip into a recession.

That sounds scary, so much so that investors may be tempted to sell their stocks today. But there are two reasons that would be a bad idea. First, the Treasury yield curve threw a false positive in the mid-1960s and the current inversion could be another false positive. In that scenario, the U.S. economy would not suffer a recession, and the stock market could continue moving higher in the coming months and years.

Second, even if the bond market is accurately predicting a future recession, investors would have no idea when to buy stocks again because it would be impossible to guess the duration or severity of the decline. During the last eight recessions, the S&P 500 has rebounded about four to five months before the economic downturn ended, and the index returned a median of 30% during that time period, according to JPMorgan. Investors that sell to avoid a recession will almost certainly miss out on that rebound.

Here's the bottom line: The bond market is currently sounding a recession alarm, and past recessions have correlated with a sharp decline in the stock market. Even so, predicting the future is impossible, so the most prudent strategy is to stay invested. However, given the elevated risk, investors can prepare for a possible recession by focusing on stocks with solid growth prospects that trade at reasonable valuations.