Understanding the Current Headwinds for the U.S. Economy and Stock Market

Headwinds are increasingly gathering strength for the U.S. economy and stock market.

For the last couple of years, bulls have dominated Wall Street. The well-known Dow Jones Industrial Average (^DJI), the key S&P 500 (^GSPC), and the forward-looking Nasdaq Composite (^IXIC) have all reached various record closing highs during this ongoing rally.

Several factors have fueled this rally, including excitement around stock splits, advancements in artificial intelligence (AI), the electoral win of President Donald Trump in November 2016, and the overall toughness of the U.S. economy. Still, signs indicate that the economic stability we relied on might not be as robust as previously thought.

A Reliable Recession Indicator from the Past 59 Years

At any moment, various statistics or events can indicate potential trouble for the U.S. economy or the stock market. For example, in 2023, we saw the first significant drop in the U.S. M2 money supply since the Great Depression. Historical data suggests that any time the M2 money supply has decreased by 2% year-over-year, it typically correlates with periods of economic depression and high unemployment.

However, the M2 money supply isn't currently forewarning of imminent economic issues. The same cannot be said for a recession probability tool from the Federal Reserve Bank of New York.

This tool analyzes the yield difference (or spread) between the 10-year Treasury bond and a three-month Treasury bill to predict the likelihood of the U.S. economy entering a recession within the next year.

In a typical scenario, the Treasury yield curve is upward sloping; longer-term bonds have higher yields compared to short-term Treasury bills. However, when the yield curve inverts, this signals potential economic troubles, as short-term T-bills then yield more than long-term bonds. Historical trends show that while not every inverted yield curve leads to a recession, every recession since World War II has been preceded by such an inversion.

The current inversion of the 10-year to three-month yield curve reached one of the steepest and longest records in history, helping push the probability of a recession above 70% in 2023. Since 1966, there has been no instance where the recession probability exceeded 32% without following through to an official downturn.

Moreover, declines in the yield curve often occur just before a recession begins. The recent economic forecasts from the Federal Reserve Bank of Atlanta even predicted a 2.4% contraction in U.S. gross domestic product (GDP) for the first quarter. A decline of this magnitude would mark the most significant drop in GDP since the Great Recession of 2009.

This contraction is likely to affect corporate earnings negatively, suggesting that the recent declines in major indices like the Dow Jones, S&P 500, and Nasdaq Composite could worsen. Historically, about two-thirds of the peak-to-trough drops in the S&P 500 from 1927 through March 2023 occurred after a recession was declared.

The Non-Linear Nature of Economic Cycles

Based on historical patterns, it appears the U.S. economy and stock market are heading toward a challenging period. However, history shows there can be two perspectives on every economic scenario. Recessions are a standard part of economic cycles that can't be avoided by fiscal or monetary policy changes.

It is vital for investors to recognize that, on average, downturns last about 10 months. Research indicates that three-quarters of recessions since World War II have resolved in less than a year. In stark contrast, economic expansions average around five years, with two growth periods since the 1940s lasting over a decade. Thus, recessions are short-lived compared to the more extended periods of economic growth.

Investors can find this disparity reflected in the stock market as well. An analysis from Bespoke Investment Group in June 2023 illustrated the benefits of long-term perspective by comparing the length of every S&P 500 bull and bear market since the Great Depression.

The results showed that bear markets, on average, last about 286 days, while bull markets typically last significantly longer at around 1,011 days, with many extending beyond 630 days. While predicting downturns and recessions isn't foolproof, historical trends suggest that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite tend to rise in value over long periods.

This creates a foundation of hope for long-term investors even amid the current economic challenges ahead.

economy, recession, markets