On March 9, 2009, the S&P 500 ended the -57 percent free fall1 that was a consequence of the global financial crisis. After unprecedented intervention by the Federal Reserve to revive the U.S. economy, the market recovered its losses in just over four years.2 By the end of September 2018, the market found itself 88 percent3 above its prior peak. The current bull market is the second longest since 1928,4 trailing only the tech boom of 1987 to 2000. Given the length of the current run in stocks, common questions on the minds of investors include “How much longer can it go?” and “When will the next bear market start?”
Since the recovery began, there have been many opportunities to ask these questions. There was the flash crash in 2010. In 2011, S&P downgraded the United States’ credit rating and the European sovereign debt crisis started. The U.S. government shut down in 2013. Crude oil prices collapsed by 77 percent in 2016. All of these events caused ripples within the stock market and were coupled with predictions of market declines or worse. Some investors reduced or completely eliminated their stock positions over fear of another significant bear market. And at first blush, this makes sense. Bear markets begin with initial declines.
The problem with using stock prices to predict bear markets is that the majority of the time, stock declines stabilize, recover back to prior values and go on to make new highs. Since 2009, the S&P 500 index has had 10 downturns between 5 percent and 10 percent and five drawdowns greater than 10 percent. Over the past five years, the market has had declines of -6 percent, -7 percent, -10 percent and -14 percent before eventually making new highs.
There may be a better way to anticipate bear markets. Throughout history, the vast majority of bear markets coincided with economic recessions. Economists have long studied various indicators to understand the relationships between different economic variables. While no single indicator is foolproof, observing a basket of indicators can help determine the probability of recession.
The most interesting indicators in this regard are called “leading” indicators. Leading indicators tend to respond first to changes in economic conditions. There are two different types of leading indicators—economic and market. Examples of economic leading indicators include initial unemployment claims, manufacturing activity, retail sales and housing permits. Market-based leading indicators include the difference in yield between various maturities of Treasury bonds and the difference in yield between lower quality bonds and Treasuries.
Two indicators are highlighted below: initial unemployment claims and the yield curve.
The chart below shows the four-week average number of individuals who have filed initial unemployment claims. The shaded bars indicate periods when the U.S. economy was in a recession. Unemployment claims begin to increase as employers respond to the slowing economy by laying off employees. Initial claims have been a good indicator of recession, as they start to rise months before the onset of a recession. Recessions have begun anywhere between five and 23 months after initial claims hit their lowest level.
As of December 2018, four-week average initial claims were at their lowest level since 1969. The trend is still downward, suggesting continued economic strength in the short run.
To explain what an inverted yield curve is, we need to understand how a normal yield curve looks. In a normally shaped yield curve, short-term bonds yield less than long-term bonds because investors demand more return for the additional risk they take by investing for a longer time period. An inverted yield curve occurs when long-term bonds, such as the 10-year Treasury, yield less than short-term bonds.
Near the end of an economic cycle, the Federal Reserve often raises short-term rates at the same time that investors begin to lose confidence in the longer term prospects for the economy. Demand for long-term bonds rises, pushing yields below those of short-term bonds. Voilà! An inverted yield curve is born.
The chart below shows the “spread,” or difference in yield, between the 10-year and the two-year Treasury note. When the blue line is below zero, the yield curve is inverted. The difference between long- and short-term yields currently is 0.21 percent. This is important because the past five recessions were preceded by an inverted yield curve, which offered a warning from 11 to 34 months ahead of time. While still positive, the yield curve is approaching inversion and should be monitored.
As mentioned before, leading indicators are not infallible and each economic cycle is unique. To paraphrase Jan Hatzius, chief economist of Goldman Sachs, economic indicators are historical observations, not laws of nature. Economic trends are much easier to identify in hindsight than in real time. This reinforces the need to analyze many different indicators to make informed decisions. Two easily understandable indicators are highlighted in this article, but in practice we monitor many more. In the aggregate, the various leading indicators we watch suggest continued growth over the coming months.
At BKD Wealth Advisors, we do not claim to be able to predict the future. Instead, we strive to build durable portfolios that fit well with our clients’ long-term goals. Properly constructed portfolios should withstand the unforeseen events that occur along the path to long-term financial success. With that said, economic indicators help assess the risk that develops in changing economic environments. The next recession and corresponding bear market are not imminent, but they grow closer every day. Reducing risks at the margin could be prudent.
For more information, contact Nick or your trusted BKD advisor.
1 S&P 500 Price Return Index, 10/9/2007 to 3/09/2009 ↩
2 S&P 500 Price Return Index, 10/9/2007 to 3/11/2013 ↩
3 S&P 500 Price Return Index, 3/11/2013 to 9/30/2018 ↩
4 https://www.yardeni.com/pub/sp500corrbeartables.pdf ↩