This Recession Indicator Hasn't Been Wrong in 59 Years: Here's What It Says Happens Next

Current economic challenges are becoming more evident for the U.S. economy and stock market.

For most of the past two and a half years, stock market optimism prevailed on Wall Street. The well-known Dow Jones Industrial Average (^DJI), the benchmark S&P 500 (^GSPC), and the growth-focused Nasdaq Composite (^IXIC) all reached multiple record-closing highs during this bull market period.

Various factors have contributed to this bullish trend, including excitement over stock splits, advancements in artificial intelligence (AI), the political climate following President Trump's election, and a seemingly resilient U.S. economy. However, there are concerns that the underlying strength of the U.S. economy may not be as solid as it appears.

Understanding a Key Recession Prediction Tool

There are always signs and data points that suggest potential trouble for the U.S. economy and market. For instance, in 2023, the M2 money supply saw its first significant decline since the Great Depression. Historical data reveals that significant drops in M2 have often correlated with periods of economic depression and high unemployment rates.

Yet, the decline in M2 does not currently seem to indicate an immediate threat to the economy. In contrast, the recession probability tool from the Federal Reserve Bank of New York raises more alarming signals.

This tool assesses the likelihood of a recession within the next year by analyzing the yield difference between the 10-year Treasury bond and the three-month Treasury bill. Typically, bond yields increase with longer maturities, meaning bonds with longer investment durations offer higher yields.

Problems arise when this usual yield structure flips, meaning short-term Treasury bills yield more than longer-term bonds. This yield curve inversion usually signals investor concerns regarding the economy's future. While not every inversion leads to a recession, it is noteworthy that every recession since World War II has followed a yield curve inversion.

The data indicates that in 2023, one of the deepest and longest inversions of this yield curve pointed to a recession probability exceeding 70%. Since 1966, no instances have shown a probability exceeding 32% without a recession occurring shortly after.

Moreover, historical patterns suggest recessions tend to follow periods when the yield curve starts to return to normal, meaning we may be at a critical junction.

For example, the Federal Reserve Bank of Atlanta's GDPNow forecast anticipated a 2.4% decline in U.S. gross domestic product (GDP) for the first quarter. If realized, this would mark the largest GDP drop since the Great Recession of 2009.

Given that recessions generally have a negative impact on company earnings, there could be further declines in stock indices like the Dow Jones, S&P 500, and Nasdaq Composite. Research from Bank of America Global Research indicates that about two-thirds of significant stock market downturns since 1927 have occurred after a recession announcement.

The Nature of Economic Cycles

Historically, it seems that the U.S. economy and stock market face a challenging outlook in the upcoming periods. However, history suggests a double-edged nature to these economic cycles.

Even though recessions are often disliked by workers and investors alike, they are a normal aspect of economic life. Importantly, the average recession over the last 80 years has lasted around ten months, and three-quarters of the recessions since World War II have resolved in under a year.

In contrast, an economic expansion period typically lasts about five years, with a few instances of growth extending beyond ten years. While downturns may soon arrive, the longer periods of economic growth overall present a favorable possibility for investors.

Furthermore, an analysis shared by Bespoke Investment Group illustrates the comparative duration of bear and bull markets since the Great Depression. On average, bear markets last around 286 calendar days, while bull markets extend over 1,011 calendar days, highlighting the potential for recovery.

Ultimately, though predicting recessions and market fluctuations is complex, historical trends suggest that the crucial indices will increase in value over long time horizons. This perspective should reassure long-term investors, even amidst concerns of an approaching recession.

Economy, Recession, StockMarket