Is a recession and bear market imminent? A virtually flawless predictive indicator weighs.

While Wall Street’s major stock indexes aren’t moving higher in a straight line, there’s no doubt that the bulls have been firmly in control since the start of 2023.

Over a period of almost 20 months, the ageless Dow Jones Industrial Average (^DJI 1.14%)landmark S&P 500 (^GSPC 1.15%)and fueled by growth Nasdaq Composite (^IXIC 1.47%) have increased in value by 23%, 45% and 68% respectively, as well as surpassing their previous all-time highs on a multitude of occasions.

However, the party on Wall Street may be coming to an end. Even though investors managed to shrug off a 1,400-point, three-session slide in the Nasdaq Composite for early August, a leading indicator with an unblemished track record dating back to 1959 portends trouble for the U.S. economy as well as stocks.

Image source: Getty Images.

This forecasting tool has not been wrong in 58 years

Let me preface this discussion by pointing out that there is no perfect predictive tool or metric. If there was a metric that could, with 100% accuracy, predict short-term directional movements for stocks, every professional and retail investor would be using it.

There are, however, several economic data points and predictive metrics that have previously correlated very closely with large movements in major stock market indices. Investors are leaning on these tools with the hope of gaining an edge in determining what’s next for Wall Street.

We’ve recently examined a number of these metrics and events that correlate strongly with lower moves in the Dow Jones, S&P 500 and Nasdaq Composite and/or portend trouble for the US economy. This includes the first notable decline in US M2 money supply since the Great Depression, one of the most expensive S&P 500 Shiller since the early 1870s, as well as the historic performance of stocks after a Federal Reserve rate cut. – the relaxation cycle. The nation’s central bank is expected to begin cutting interest rates next month.

But the Federal Reserve Bank of New York’s recession probability indicator may be the most damning of all.

The NY Fed’s Recession Tool measures the likelihood of a US recession occurring in the next 12 months by examining the spread (ie, the yield spread) between 10-year Treasury bonds and three-month Treasury bills.

When the US economy is strong and investors are bullish, the Treasury yield curve slopes up and to the right. This means that bonds maturing in 10 or 30 years will have higher yields than Treasury bills maturing in one year or less. It is normal to receive a higher return when your capital is tied up for a longer period of time.

US Recession Probability Data by YCharts. Gray areas denote US recessions.

Conversely, when there are concerns about the health of the US economy, we see the yield curve invert, with short-term Treasuries yielding higher yields than longer-term Treasuries. While not every yield curve inversion means a US recession is imminent, every US recession since World War II has been preceded by a yield curve inversion.

As you can see from the latest monthly update of the NY Fed’s Recession Forecasting Model, which highlights the longest continuous yield curve inversion in history, there is a 56.29% chance that a US recession will outline until July 2025.

Since 1959, there has been only one instance (October 1966) when the probability of a US recession exceeded 32% and an official economic contraction, as declared by the National Bureau of Economic Research (NBER), did not occur. In other words, a recession probability of 32% or greater over the past 58 years has signaled without fail a future recession for the US economy.

Although the economy and the stock market are not linked at the hip, the overall health of the economy is do what matter for corporate America. If the US economy weakens and unemployment rises, it’s almost a lock to have a negative impact on corporate earnings.

Data collected and analyzed by Bank of America Global Research finds that about two-thirds of the S&P 500’s peak-to-trough declines occur after, not before, the NBER declares a recession. With a key recessionary ingredient firmly in place, the implication is that stocks could fall significantly — that is, into a bear market — in the near future.

Image source: Getty Images.

Patience isn’t just a virtue — it’s a necessary ingredient for success on Wall Street

As much as US recessions and stock market corrections/bear markets may displease investors, these are normal and inevitable aspects of the economic and investment cycle.

But if you step back, broaden your focus, and let patience and perspective be your guides, you’ll see that these occasional moments of panic and disappointment serve as opportunities for long-term investors to take advantage of potential price. time-tested business dislocations on Wall Street.

The key thing to understand about the business cycle is that it is not linear. Although recessions may be inevitable, nine of the 12 official recessions since the end of World War II were resolved in less than a year. By comparison, almost every economic expansion has stalled for several years, including two growth spurts that topped the decade mark. Betting on the growth of the US economy over time was arguably the smarter move, even with the occasional recession sprinkled in.

The non-linear nature of business cycles also translates into Wall Street’s major stock indexes.

In June 2023, researchers at Bespoke Investment Group posted a dataset on X (the social media platform formerly known as Twitter) that examined the calendar length of each bull and bull market in the S&P 500 dating back to the beginning of the year. The Great Depression of September 1929.

It’s official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. In the previous bear market, the index fell 25.4% in 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

— Bespoke (@bespokeinvest) June 8, 2023

Over a 94-year period, the average duration of the 27 recorded S&P 500 bear markets was just 286 calendar days, or about 9.5 months. On the other hand, the typical S&P 500 market lasted 1,011 calendar days, which equates to about two years and nine months.

You’ll also notice that the longest bear market in S&P 500 history, which occurred between January 1973 and October 1974, is still shorter than 13 of the 27 S&P 500 bull markets since September 1929.

At the end of the day, we will never be able to accurately forecast when a correction or bear market will begin, how long it will last, or where the final low will be. But history shows conclusively that patience and perspective are powerful tools for investors that can help them navigate any short-term turbulence or uncertainty that Wall Street or the U.S. economy throws their way.