Looking to predict the start of the next U.S. recession? Turn your gaze away from the stock market.
As shares have swooned in recent weeks, some investors have begun to worry that the declines could signal the beginning of the end of the U.S. economic expansion.
Judging by history, however, U.S. stock markets are more panicky than prescient when it comes to forecasting recessions.
On the one hand, every one of the 11 recessions since 1948 was preceded by a decline of at least 10 per cent in the Standard & Poor's 500 stock index (the declines anticipated the start of the recession by anywhere from 13 months to a few weeks).
But over that time period, there have been 32 such stock-market declines in total, notes Sam Stovall, U.S. Equity Strategist at S&P Capital IQ in New York – or a one-in-three track record.
Investors are like "hyperactive first graders playing musical chairs, always trying to out-anticipate the other as to when the music will stop," says Mr. Stovall.
That can lead to situations – including the crash of 1987 and the market corrections in 2010 and 2011 – in which stocks plunge but the real economy remains unscathed.
The tendency of stock markets to overreact is the subject of a famous quip by Nobel Prize-winning economist Paul Samuelson, who once wrote that stock markets have predicted "nine out of the last five recessions."
Mr. Stovall notes that of the 11 recessions in the past 70 years, eight of them were preceded by bear markets, or declines of 20 per cent or more. U.S. markets have not crossed that threshold: the S&P 500 is down 10 per cent since May of last year and 6 per cent since the start of 2016.
Of course, there are ways in which plunging stocks can have ripple effects on the real economy. When shares fall, investor anxiety rises, reducing appetite for riskier assets. That means there are fewer buyers, for instance, for certain kinds of corporate bonds, for which prices fall and yields rise. The result is that it becomes somewhat more difficult for companies to borrow, tamping down economic activity.
"You are seeing some degree of credit-market tightening," says Tim Duy, an economics professor at the University of Oregon and a former economist for the U.S. Treasury Department. "If that's going to cause a recession, it's going to be 12 months down the road."
Prof. Duy says the current market conditions remind him of 1986, when low oil prices and a high U.S. dollar caused an "earnings recession" – two or more consecutive quarters in which earnings declined relative to a year earlier. The U.S. stock market is already in the grips of an earnings recession, which started in the second quarter of last year.
To forecast the likelihood of a contraction in economic output, many economists avoid share prices and company earnings and focus instead on the shape of the U.S. yield curve – or the difference between short- and long-term interest rates on government bonds.
According to the New York Federal Reserve, the yield curve has predicted every recession since 1960, with only one false signal. A few quarters prior to the start of recessions, the yield curve has "inverted": a situation in which short-term interest rates are higher than long-term interest rates. It's a signal that investors believe a contraction in economic activity isn't too far off, which would oblige the U.S. Federal Reserve to cut benchmark interest rates.
While the yield curve has been a reliable indicator in the past, that was before the era of ultra-low interest rates. With short-term interest rates still near zero, it's hard to see how long-term rates could drop even lower.
Prof. Duy argues that if the U.S. is headed toward a recession, yields on 10-year U.S. government bonds will plunge toward zero – not lower than short-term rates, but nearly equal to them, making the yield curve very flat, although not actually inverted.
Still, he's an optimist where the U.S. economy is concerned, noting that if one looks at jobless claims or housing starts – also useful leading indicators for a recession – there's no cause for immediate alarm. "I pencil in recession in 2018, rather than 2017," he said.