While a surging S&P 500 index may seem like a comforting signal of economic prosperity, this view might be overly optimistic, perhaps even misleading. It’s essential to remember that stocks’ gains are not an unequivocal indication of confidence that there’s no imminent recession.
The popular notion that the stock market is a forward-looking economic predictor is a flawed belief that reinforces a self-sustaining cycle of misplaced confidence. Examining the S&P 500 US equity benchmark data dating back more than 95 years uncovers a different narrative. Of the 15 recessions recorded in this period, the stock market only foresaw a downturn beforehand on 10 occasions, offering a scant lead time of two to three months. Furthermore, in two instances, the market peaked concurrently with the recession onset, and twice it peaked afterward. Most notably, the market rallied throughout the 1945 post-WWII recession, a clear reminder that it can, and has, missed the mark.
It’s crucial to remember that our interpretation of this data is retrospective, and recognizing a recession in real-time is notoriously difficult. The official declaration of a recession’s onset typically occurs in hindsight, with the National Bureau of Economic Research (NBER) often delaying its announcement for several months. This delay can fuel overly optimistic forecasts by the Federal Reserve and investors alike, potentially setting up a trap of complacency.
Drawing parallels with recent economic history provides a cautionary tale. For instance, in October 2007, the Federal Open Market Committee (FOMC) and the broader market were buoyed by a narrative of economic resilience and a potential soft landing. Ironically, this was the same month the S&P 500 peaked, with the onset of the Great Recession only two months away. This highlights that every previous economic downturn has been consistently underestimated.
Recent updates on the Senior Loan Officer Opinion Survey (SLOOS), one of the most reliable predictors of US recessions, suggest that a downturn might commence toward the end of the year. Concurrently, the Brookings Institution warns of a looming halt in aggressive consumption as consumers deplete their cash reserves. This effect will be compounded once the student loan repayment amnesty ends this month, further squeezing consumers’ finances.
Despite the market’s continued rally, several signs point toward a looming economic contraction. The US Misery Index is projected to rise by year-end, indicating a deteriorating macro environment for consumers precisely when personal finances may be most strained. The potential impacts of policy tightening, the yield curve, and the ISM are all suggestive of a recession likely beginning in the fourth quarter.
Consequently, it’s crucial for investors to be wary of the equities end game. With the exception of the 1945 anomaly, the average S&P 500 decline associated with the previous 14 recessions was a staggering 35%. This should serve as a stark reminder that a bull market isn’t necessarily a portent of continued economic prosperity, but could just as likely be the calm before the storm.
All in all, the stock market’s gains should not lull investors into a false sense of security. History has shown time and time again that the market’s predictive abilities are far from perfect, and it is incumbent upon us to read the signs of a potentially imminent recession accurately. As investors, it’s crucial to navigate these deceptive waters with a clear understanding of the market’s limitations and a keen eye on the myriad other indicators that could provide a more nuanced view of the economic landscape.
It’s also important not to discount the looming debt crisis which we wrote about here.
