Predictor Signal for Economic Downturn Shows Consistency over 59 Years, Offers Insight into Future Economic Scenario
A Wild Ride on Wall Street: The electricity and chaos of the stock market
For nearly three years, the stock market has been a thrilling rollercoaster ride. The mighty Dow Jones Industrial Average (^DJI 1.65%), the resilient S&P 500 (^GSPC 2.13%), and the tech-centric Nasdaq Composite (^IXIC 2.61%) have all hit record highs during this spectacular bull market rally.
The market has experienced a whirlwind of events propelling it forward, including:
- Stock-split euphoria - Exciting distribution of shares among investors, boosting ownership and optimism.
- Artificial Intelligence (AI) revolution - The coming surge of AI-driven technologies and breakthroughs capturing imaginations and wallets.
- President Donald Trump's victory in November - Political triumph spurring a sense of economic nationalism and robustness.
- The unyielding resilience of the U.S. economy - A robust foundation for growth despite challenges and obstacles.
However, upon further examination, the U.S. economy might not be as solid as it seems.
Trouble on the Horizon: Decoding the Economic Weather
At any given moment, the U.S. economy could be faced with data points, events, or statistics foreshadowing turbulence. For instance, in 2023, we witnessed the first substantial decline in U.S. M2 money supply since the Great Depression. Such declines, when occurring over a year-over-year basis, have historically correlated with periods of depression and high unemployment in the U.S.
It seems the federal reserve's recession probability tool, however, isn't flashing those dire signals. This tool uses the difference in yield (also known as the spread) between the 10-year Treasury bond and the three-month Treasury bill to gauge the likelihood of a recession in the next 12 months.
Typically, the Treasury yield curve (a visual representation of various bond and bill maturity dates, plotted by yield over time) ascends and tilts to the right. This means that investments with longer maturities will provide higher yields than short-term options, rewarding investors for tying up their resources.
However, when the yield curve inverts – short-term T-bills offering greater yields than long-term bonds – anxiety about the future health of the U.S. economy prevails. Although not every inversion ends in a recession, the trend highlights a key pattern: since World War II, every recession has been preceded by a yield-curve inversion.
US Recession Probability data by YCharts. Dark periods represent U.S. recessions.
As the chart reveals, an epic inversion of the 10-year/three-month yield curve in history occurred in 2023, driving the recession probability to a staggering high of over 70%. Since 1966, there hasn't been a single instance where the probability of a U.S. recession has risen beyond 32%, and a downturn failed to transpire.
But that's just half of an essential data set vital for predicting U.S. recessions over the last 59 years. Additionally, recessions have often emerged when the yield curve begins to recover. More precisely, economic downturns have commonly taken shape as, or shortly after, the yield curve uninverts (i.e., returns to normal), which is where we currently stand.
Perhaps coincidentally, the Federal Reserve Bank of Atlanta's March 6 GDPNow forecast estimated a 2.4% contraction in U.S. Gross Domestic Product (GDP) for the first quarter. This dip in GDP would mark the steepest decline since the Great Recession in 2009.
Given that recessions typically influence corporate earnings negatively, the implication is that the recent sell-off in the Dow, S&P 500, and Nasdaq Composite might escalate. According to an analysis from Bank of America Global Research, around two-thirds of the S&P 500's peak-to-trough drawdowns from 1927 to March 2023 occurred after a U.S. recession was declared.
Live Wire: The Pulsating Energy of Economic Cycles
Taking sole stock of historic precedent, the U.S. economy and stock market might be gearing up for a challenging couple of quarters. However, history has a two-sided narrative:
- While recessions might cause unease for ordinary Americans and investors, they are an inherent aspect of the economic cycle. Recessions happen only due to natural economic processes.
- The key perspective for investors lies in realizing that recessions typically last approximately 10 months, and a sizable portion (three-quarters) of recessions in the past 70 years have been resolved in under a year.
In contrast, the average economic expansion has persisted for around five years. Over the past 80 years, there have been only two growth spurts that lasted more than 10 years. Recessions may be inevitable, but they make a weak showing compared to economic expansions in terms of duration.
This remarkable disparity is noticeable on Wall Street, too.
It is now official: We have entered a new bull market. The S&P 500 has soared 20% from its October 2022 closing low, surpassing the threshold that defines a bull market. The previous bear market saw the index fall 25.4% over a period of 282 days[1].
It's true that the data in this analysis is 21 months old, but an analysis published on social media platform X in June 2023 by Bespoke Investment Group beautifully demonstrates the value of patience, perceptiveness, and positivity in investing.
Bespoke compared the time length of every S&P 500 bull and bear market dating back to the inception of the Great Depression in September 1929. This revealed 27 separate bear and bull markets.
On one hand, the average bear market resolved in 286 calendar days (around 9.5 months)[2]. No bear market extended beyond 630 calendar days. On the other, the average S&P 500 bull market persisted for 1,011 calendar days over a 94-year period, with roughly half of all bull markets lasting beyond 630 calendar days[2].
Although there is no foolproof method for predicting recessions and market downturns, there is a valuable lesson to be gleaned from Wall Street: Over the long term, the Dow Jones, S&P 500, and Nasdaq Composite will rise in value. Even if a recession looms, this piece of information should bring joy and encouragement to the hearts of long-term investors.
[1] https://t.co/H4p1RcpfIn[2] pic.twitter.com/tnRz1wdonp[3] June 8, 2023
- In 2023, the first substantial decline in U.S. M2 money supply since the Great Depression raised concerns about potential turbulence for the U.S. economy.
- Despite this decline, the federal reserve's recession probability tool did not show the anticipated dire signals, but an epic inversion of the 10-year/three-month yield curve in the same year led to a staggering high recession probability of over 70%.
- The shed light on historical data suggests that recessions, while a natural part of the economic cycle, may last about 10 months on average, but economic expansions often persist for around five years.
- According to a report by Bank of America Global Research, approximately two-thirds of the S&P 500's peak-to-trough drawdowns from 1927 to 2023 occurred after a U.S. recession was declared, hinting at the potential escalation of the recent sell-off in the Dow, S&P 500, and Nasdaq Composite.
