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

For the better part of the last two and a half years, the bulls have been in firm control on Wall Street. The mature stock-powered Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth-oriented Nasdaq Composite (NASDAQINDEX: ^IXIC) all achieved numerous record-closing highs during the current bull market rally.

The catalysts behind this rally have been abundant and include stock-split euphoria, the artificial intelligence (AI) revolution, President Donald Trump's November victory, and the resilience of the U.S. economy. Unfortunately, the foundation of the U.S. economy may not be as strong as advertised.

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Image source: Getty Images.

This recession-forecasting tool was last wrong in 1966

At any given moment, there's bound to be one or more data points, events, or correlative statistics that spell trouble for the U.S. economy and/or stock market. For example, in 2023 we witnessed the first sizable decline in U.S. M2 money supply since the Great Depression. The very few times M2 has dropped by 2% on a year-over-basis, when back-tested more than 150 years, correlate with periods of depression and double-digit unemployment in the U.S.

But M2 money supply doesn't appear to be signaling imminent trouble for the U.S. economy. The same can't necessarily be said for the Federal Reserve Bank of New York's recession probability tool.

The New York Fed's recession-forecasting tool takes into account the difference in yield (known as spread) between the 10-year Treasury bond and three-month Treasury bill to decipher how likely it is that the U.S. economy will fall into a recession over the next 12 months.

Typically, the Treasury yield curve, which is a depiction of various bond and bill maturity dates mapped out by yield over time, slopes up and to the right. This is to say, bonds set to mature in 10, 20 or 30 years are going to bear higher yields than Treasury bills maturing in a year or less. Ideally, the longer your money is tied up in an interest-bearing investment vehicle, the higher the yield should be.

Where things get wonky is when the Treasury yield curve inverts. This is where the yield on short-term T-bills is higher than for long-term bonds. Yield-curve inversions typically occur when investors are concerned about the outlook for the U.S. economy. Although not every yield-curve inversion has been followed by a recession, it's worth pointing out that every recession since World War II has been preceded by a yield-curve inversion.

US Recession Probability data by YCharts. Grey areas denote U.S. recession.

As you'll note from the chart, one of the steepest (and lengthiest) inversions of the 10-year/three-month yield curve in history led to a recession probability that peaked at north of 70% in 2023. Since October 1966, there hasn't been a single instance where the probability of a U.S. recession has surpassed 32% and an official downturn failed to materialize.

But this is just one-half of an important data set that's helped to accurately forecast U.S. recessions over the last 59 years. Additionally, recessions have almost always manifested when the yield curve has begun recovering. In other words, economic downturns have often taken shape as, or very shortly after, the yield curve uninverts (i.e., returns to normal) -- and that's where we are right now.

Perhaps it's no coincidence that the Federal Reserve Bank of Atlanta's March 6 GDPNow forecast called for a 2.4% contraction in U.S. gross domestic product (GDP) for the first quarter. Putting aside the wild GDP fluctuations during the COVID-19 pandemic, a 2.4% decline in GDP would mark the biggest decline since the Great Recession in 2009.

Since recessions tend to adversely impact corporate earnings, the implication is that the recent sell-off in the Dow Jones, S&P 500, and Nasdaq Composite might accelerate. According to an analysis from Bank of America Global Research, approximately two-thirds of the S&P 500's peak-to-trough drawdowns from 1927 through March 2023 have occurred after a U.S. recession was declared.

Image source: Getty Images.

Economic cycles aren't linear, and that's music to the ears of investors

Based solely on historic precedent, the U.S. economy and stock market appear to be headed for a challenging couple of quarters. But that's the great thing about history -- there are two sides to every coin.

As much as working Americans and investors might dislike downturns in the U.S. economy, no amount of fiscal or monetary policy changes can prevent them from happening. Recessions are a normal part of the economic cycle.

But here's the key point about recessions that investors should home in on: The average downturn over the last 80 years has lasted roughly 10 months. Three-quarters of the 12 recessions that have occurred since the end of World War II were resolved in less than a year.

On the opposite end of the spectrum, the average economic expansion has endured for around five years. Over the last eight decades, there have been two growth periods that surpassed the 10-year mark. While recessions may be perfectly normal, they take a clear back seat to economic expansions, in terms of sheer length.

This nonlinear disparity is something investors can find on Wall Street, as well.

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

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

-- Bespoke (@bespokeinvest) June 8, 2023

Even though the data set is 21 months old, an analysis published on social media platform X in June 2023 by Bespoke Investment Group perfectly lays out the advantages of perspective, time, and optimism when investing in the stock market.

Bespoke compared the calendar-day length of every S&P 500 bull and bear market, dating back to the start of the Great Depression in September 1929. This worked out to 27 separate bear and bull markets.

On one hand, the average bear market resolved in 286 calendar days, or roughly 9.5 months. Data also showed that no bear market surpassed 630 calendar days. On the other, the average S&P 500 bull market lasted for 1,011 calendar days over a 94-year period, with approximately half of all bull markets enduring for more than 630 calendar days.

While there's no guaranteed method for predicting recessions and stock market downturns, the closest thing you'll get to a guarantee on Wall Street is that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite will increase in value over long periods. That's music to the ears of long-term investors, even if a possible recession is around the corner.

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Bank of America is an advertising partner of Motley Fool Money. Sean Williams has positions in Bank of America. The Motley Fool has positions in and recommends Bank of America. The Motley Fool has a disclosure policy.