Is Wall Street on the Verge of a Crash? The Fed’s Most-Trusted Recession Indicator Weighs In.

When examined over long periods, no asset class has more consistently delivered for investors than the stock market. When compared to gold, oil, housing, and even Treasury bonds, the average annual return of stocks over the very long term handily outpaces these other asset classes.

However, things become less certain when the lens is narrowed. Over the previous four years, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth-powered Nasdaq Composite (NASDAQINDEX: ^IXIC) have traded off bear and bull markets in successive years.

Truth be told, there is no foolproof method for accurately predicting short-term directional moves or crashes in Wall Street’s three major stock indexes — but that doesn’t stop investors from trying to gain an advantage.

Though there’s no concrete way to accurately forecast where the Dow Jones, S&P 500, and Nasdaq Composite will head next, there are a relatively small number of metrics and predictive indicators that have strongly correlated with directional moves in the stock market’s major indexes. One of these predictive tools suggests trouble may be brewing in paradise, which has the potential to send Wall Street over the proverbial edge.

Image source: Getty Images.

Are stocks about to fall off a cliff?

The forecasting tool in question that’s piquing the interest of Wall Street skeptics is the Federal Reserve Bank of New York’s recession probability indicator.

Every month for more than six decades, the NY Fed’s recession probability tool has analyzed the spread (difference in yield) between the 10-year Treasury bond and three-month Treasury bill (T-bill) to determine how likely it is that a U.S. recession will crop up over the coming 12 months.

The vast majority of the time, the Treasury yield curve slopes up and to the right. In other words, Treasury bonds that aren’t set to mature for 30 years will offer higher yields than T-bills that are set to mature in, say, a month or a year. Yields should increase the longer your money is invested in an interest-bearing asset.

But as the 10-year/three-month yield spread has shown over the past 65 years, the yield curve doesn’t always behave as planned. Occasionally, the yield curve inverts, which represents an instance where T-bills sport higher yields than Treasury bonds maturing a long time from now. When the yield curve inverts, it’s typically a sign that investors are worried about the near-term outlook for the U.S. economy.

Now here’s the quirk: A yield-curve inversion doesn’t guarantee the U.S. economy will dip into a recession. However (and here’s the key “however’), every recession since the end of World War II in September 1945 has been preceded by a yield-curve inversion. It represents something of a warning to investors that the U.S. economy and stock market could be teetering on disaster.

US Recession Probability Chart

US Recession Probability Chart

As you can see from the data released in recent days by the NY Fed, there’s a 58.31% probability of a recession taking shape by or before February 2025. Although this isn’t the highest recent reading from this predictive tool, it remains one of the highest recession-probability forecasts over the past 42 years.

There are two things worth pointing out from the 65 years of reported yield-curve data from the NY Fed. To start with, this predictive tool can be wrong. In October 1966, the likelihood of a U.S. recession taking shape surpassed 40% without a downturn in the U.S. economy materializing. It’s not an infallible forecasting tool.

On the other hand, it’s only been wrong one time spanning 65 years and has a perfect track record over the last 58 years. Since October 1966, a recession probability of 32% or above has, without fail, eventually forecast a U.S. recession.

Even though the stock market doesn’t mirror the performance of the U.S. economy, corporate earnings do ebb and flow based on the health of the economy. Historically, two-thirds of the S&P 500’s drawdowns have occurred after, not prior to, a recession being declared by the National Bureau of Economic Research. Put another way, a recession would, indeed, be expected to decisively knock the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite off their respective perches. While a rapid crash may not occur, meaningful downside would be the expectation.

A smiling person reading a financial newspaper while seated in their home.

Image source: Getty Images.

Patience has a perfect track record on Wall Street

Truth be told, the NY Fed’s trusted recession probability tool is just one of a couple of metrics that appears to spell trouble for the U.S. economy and stock market. In particular, M2 money supply is meaningfully contracting for only the fifth time since 1870, and the Conference Board Leading Economic Index (LEI) is working on one of its longest consecutive declines dating back more than 60 years. All signs appear to point to a sizable downturn for the Dow Jones, S&P 500, and Nasdaq Composite.

While this may not be the rosiest of near-term forecasts, patience has a way of righting the ship when it comes to investing on Wall Street.

For example, in the 78 years since World War II ended, the U.S. economy has navigated its way through a dozen recessions. Only three of these 12 downturns reached 12 months in length, and none surpassed 18 months. Based on what history tells us, recessions are short-lived events.

Conversely, periods of economic growth tend to stick around for multiple years. While there are a few instances of short-lived expansions, there are two periods of growth since 1945 that lasted at least a decade. Statistically speaking, it’s a considerably smarter move to bet on the American economy (and its underlying businesses) to grow over time.

It’s a similar story on Wall Street. According to analysts at Bespoke Investment Group, there’s a marked disparity between bear and bull markets in the S&P 500.

Last June, Bespoke published a dataset that revealed the length of every bear and bull market in the S&P 500 dating back to the start of the Great Depression in September 1929. The 27 S&P 500 bear markets have lasted an average of just 286 calendar days (about 9.5 months), with the longest enduring 630 calendar days in 1973 to 1974.

By comparison, the average S&P 500 bull market has lasted for 1,011 calendar days (roughly two years and nine months), with 13 of the 27 bull markets since September 1929 sticking around for a longer number of calendar days than the lengthiest S&P 500 bear market.

No matter what the U.S. economy or Wall Street has thrown investors’ way, patience has always paid off. Eventually, stock market corrections and bear markets are cleared away by bull market rallies. Even if 2024 turns out to be a rough year for equities, it could represent a blessing in disguise for opportunistic long-term investors.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Is Wall Street on the Verge of a Crash? The Fed’s Most-Trusted Recession Indicator Weighs In. was originally published by The Motley Fool