Recession Watchlist Grows as Historic Indicator Flashes Red
By April Fowell
Wall Street has experienced volatility in recent years, with major indexes like Dow Jones, S&P 500, and Nasdaq Composite fluctuating between bull and bear markets. Investors often speculate on their future directions.
The Conference Board Leading Economic Index (LEI) is a crucial recession indicator back-tested to 1959, incorporating financial and nonfinancial inputs. The LEI, showing a 21-month decline, suggests a nearly 63% chance of a recession by December 2024.
Another indicator, the yield curve inversion, predicted by the Federal Reserve Bank of New York's tool, has historically foreshadowed U.S. recessions for about 80 years. With a nearly 63% probability, the yield curve inversion indicates a recession by December 2024. Additionally, the M2 money supply, when declining by at least 2%, historically led to deflationary depressions with elevated joblessness, serving as a consistent indicator of economic weakness over the last 154 years.
Since the start of this decade, investing on Wall Street has been nothing short of an experience. In recent years, three major indexes have fluctuated between bull and bear markets: the venerable Dow Jones Industrial Average, the broad-based S&P 500 and the innovation-focused Nasdaq Composite.
Investing on Wall Street entails some volatility, but that doesn't stop investors from speculating where the Dow Jones, S&P 500, and Nasdaq Composite will go next. When back-tested to 1959, one recession barometer has a perfect record and is a significant indicator of what could happen next for the stock market and the U.S. economy.
To be very clear, no predictive indicator can ever be ideal or 100% accurate in predicting the direction of movement of the three main stock indexes. However, some indicators, economic data, and forecasting instruments have remarkably strong long-term relationships with changes in the stock market. Of those essential instruments, the Conference Board Leading Economic Index (LEI) happens to be one.
The LEI is reported on a monthly basis and has ten inputs. The performance of the S&P 500 and the exclusive Leading Credit Index are two of its three financial inputs. The remaining seven inputs are nonfinancial and include metrics such as the ISM Manufacturing New Orders Index, average weekly manufacturing hours, and average weekly first unemployment insurance claims, among others.
As stated by the Conference Board itself, "The LEI is a predictive variable that anticipates (or "leads") turning points in the business cycle by around seven months." Put another way, the LEI may be able to predict economic weakness before the National Bureau of Economic Research formally declares a recession.
The six-month growth rate showed a fall of 2.9%, while the LEI fell by 0.1% for the month of December. Even while this is a smaller loss than in past months and rolling six-month periods, it was the 21st straight month that the LEI has declined. Only the 22-month slump during the 1973-1975 recession and the 24-month dip during the financial crisis (2007-2009) have lasted longer when backtested to 1959.
Still, the length of successive falls in LEI tells only half of the tale. When predicting downturns in the US economy, the LEI's year-over-year change has historically been even more predictive.
There are several examples where the year-to-year change in the LEI has decreased by a small 0.1% to 3.9% when back-tested over a 65-year period. Although these are warning signs, these levels don't portend a US recession. In contrast, since 1959, every year-over-year decline in the LEI of at least 4% has been associated with a recession in the United States.
Even while the current year-over-year loss in the LEI has slowed down recently, it is still over twice as large as the 4% drop that is considered arbitrary and has traditionally been the perfect predictor of U.S. recessions. To put it simply, the LEI indicates that a recession is quite likely to occur in 2024.
Although the U.S. economy and equities are not inextricably linked, a worse economy is anticipated to have a negative effect on business profitability. Most of the S&P 500's losses historically have happened after a recession has been formally declared, not before. To put it briefly, the LEI seems to be predicting a challenging year for stocks.
Recession Indicators: Yield Curve Inversion and M2 Money Supply
The recession likelihood tool from the Federal Reserve Bank of New York is the first recession indicator with an almost flawless record of predicting downturns. Using the gap, or yield differential, between the 10-year Treasury bond and the three-month Treasury bill, the NY Fed's prediction tool calculates the probability that a recession will occur within the next 12 months.
Longer-dated bonds typically offer higher yields than short-term bills, and the Treasury yield curve typically slopes up and to the right. When the yield curve inverts and the rates on short-term bills exceed those on longer-dated bonds, problems might occur. Recession probability increases with inversion steepness.
However, since World War II, an inversion of the yield curve has preceded every recession. It has been a reliable indicator of US recessions for about 80 years.
The yield-curve inversion is at its sharpest point in around forty years, and the New York Fed's tool predicts that there is almost a sixty-three percent chance that a recession will occur by December 2024 at the latest.
M2 money supply is the other possibly damaging indicator in the near term. M2 adds money market accounts, savings accounts, and certificates of deposit (CDs) with balances under $100,000 to M1 (cash and coins in circulation, coupled with demand deposits in a checking account).
One of those measurements that increases over time so continuously that some economists overlook it is M2. M2 tends to rise over extended periods of time because transactions in rising economies demand more currency.
Nonetheless, throughout the last 154 years, there have been five periods in which the M2 money supply has decreased by at least 2% annually (1878, 1893, 1921, 1931-1933, and 2023-current). In the four prior cases in which M2 declined significantly, deflationary depressions with elevated rates of joblessness ensued.
The premise here is that customers buy less discretionary goods and services as the money supply decreases, which hurts business profits. The lesson is that, despite significant changes in monetary and fiscal policy over the last century, a discernible drop in M2 has consistently served as an indicator of economic weakness.