Over long periods, Wall Street is a money machine that's handily outperformed the average annual returns of commodities like oil and gold, bonds, and bank certificates of deposit. But on a year-to-year basis, the stock market can be somewhat of a crapshoot, as investors found out last year.
When the curtain closed on 2022, the iconic Dow Jones Industrial Average (^DJI), benchmark S&P 500 (^GSPC), and technology-dependent Nasdaq Composite (^IXIC) all entered respective bear markets and produced their worst returns since 2008. The abysmal performance of these core stock indexes has a lot of investors asking whether a U.S. recession is unavoidable.
Unfortunately, there is no crystal ball that allows us to look into the future and know with concrete certainty whether a recession is coming. However, there is a somewhat off-the-radar indicator that's correctly forecasted U.S. recessions — without fail — over the past 70 years. Based on historic data, it's quite clear what happens next.
This recession-forecasting index hasn't been wrong since the early 1950s
Many tenured investors are probably familiar with the U.S. ISM Manufacturing Index released by the Institute of Supply Management (the “ISM” in the Index's name) each month. This index, also referred to as the Purchasing Managers Index, is based on data gathered from the responses of executives with more than 400 industrial companies. Without getting too far into the weeds, the ISM Manufacturing Index is a composite of five seasonally adjusted components: new orders, employment, production, supplier deliveries, and inventories.
Thankfully, you don't have to be an economist or even a tenured investor to understand ISM Manufacturing Index readings.
Imagine there's a scale between 0 and 100 and you've drawn a line in the sand at 50. This is your baseline. Any figure above 50 represents expansion in manufacturing activity in the industrial sector, whereas any figure below 50 implies contraction in manufacturing activity. The further you move from 50, the more pronounced the strength or weakness in manufacturing activity. As I said, it's all pretty straightforward, and ISM handles all the calculations.
However, the U.S. ISM Manufacturing Index isn't the indicator with the immaculate track record of calling recessions for the past 70 years. That honor goes to one of its subcomponents: the U.S. ISM Manufacturing New Orders Index.
As its name clearly states, this index examines new order activity within the industrial sector. Even though the U.S. has clearly become more reliant on technology and is no longer the manufacturing powerhouse it once was, manufacturing activity remains an important telltale of U.S. economic growth or contraction.
The key level for the U.S. ISM Manufacturing New Order Index has been 43.5. With one exception in the early 1950s, the other 12 instances when the U.S. ISM Manufacturing New Orders Index has fallen below 43.5 since the start of 1948 have resulted in the U.S. economy falling into a recession.
Where is the U.S. ISM Manufacturing New Orders Index right now, you ask? It came in at a disappointing 42.5 in January 2023. Based on this reading and the history of this index over the past 70 years, a recession would appear imminent.
Another high-profile recession-prediction tool agrees that a recession is likely
Keep in mind that the U.S. ISM Manufacturing New Orders Index is far from the only metric sounding a warning for the U.S. economy and Wall Street.
Just two weeks ago, I examined one of Wall Street's most tried-and-true recession-predicting tools: the Federal Reserve Bank of New York's recession probability indicator. This is an indicator that takes its cues from the Treasury bond yield curve.
Without getting overly technical, the Treasury yield curve typically slopes up and to the right. In other words, Treasury bonds set to mature a long time from now (e.g., 10-year and 30-year bonds) have higher yields than Treasury bonds maturing in the short term (e.g., three-month bonds). Investors should be rewarded with a higher yield for having their capital tied up for a longer time frame.
The warning sign of a recession occurs when the yield curve inverts. When short-term Treasury bond yields surpass long-term Treasury bond yields, it's a clear indication that investors are concerned about the U.S. economic outlook. Recently, the spread between the three-month and 10-year Treasury notes was at its largest inversion level in four decades.
Similar to the ISM Manufacturing New Orders Index, the NY Fed's recession probability indicator has a well-defined line-in-the-sand figure that's accurately forecasted recessions since the late 1950s. With the exception of October 1966, when the NY Fed's recession probability indicator peaked at 41.14%, every other instance when it surpassed 40% has resulted in a recession taking shape within 12 months.
In December 2022, the probability of U.S. recession predicted by the Treasury spread stood at 47.31%. Once again, an indicator with a flawless track record for more than a half-century suggests a recession is in the cards for the U.S. in 2023.
Don't be afraid to put your money to work if a recession does materialize
On the one hand, it's worthwhile for investors to recognize that the stock market hasn't bottomed out prior to a recession in a long time. While it's perfectly normal for stocks to trough before a U.S. recession ends, it's incredibly unusual for equities to enter a new bear market before a recession even materializes.
However — and this is a pretty important “however” — on the other hand, recessions have a history of giving patient investors opportunities to buy into high-quality businesses at a discount. Though stock market corrections and bear markets can be unpleasant over the short run, history has shown that every correction, crash, and bear market throughout history was eventually cleared away by a bull market. This holds true for every sizable downturn in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.
For instance, annually released data by Crestmont Research has shown that there literally (not figuratively…literally) isn't a bad time to put your money to work if you're a long-term investor. Crestmont examined the rolling 20-year total returns, including dividends paid, of the S&P 500 since the beginning of 1900. What it found was that all 103 ending years examined (1919-2021) would have produced a positive total return. In short, if, hypothetically, you bought an S&P 500 tracking index at any point since the beginning of 1900 and held it for 20 years, you made money.
If you're wondering where to invest during a recession (assuming the two recession indicators discussed above are correct), might I suggest starting your research with dividend stocks? Companies that pay regular dividends to their shareholders are often profitable on a recurring basis and have previously navigated through economic downturns. Additionally, income stocks have an extensive track record of outperforming publicly traded companies that don't offer payouts.
It also doesn't hurt to think defensively when economic uncertainty arises. For example, no matter how poorly the U.S. economy and/or stock market perform, consumers will still need food and beverages, detergent, toilet paper, toothpaste, and other nondiscretionary goods. Likewise, electricity consumption doesn't change much, and people will still get sick and require prescription drugs, medical devices, and various healthcare services. The point is that corporate activity doesn't grind to a halt just because the U.S. economy hits a speed bump.
With many top-notch stocks well below their all-time highs, the current bear market and possible U.S. recession may represent a once-in-a-decade buying opportunity for long-term investors.
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Originally published on Fool.com
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.