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Narrator: The stock market is falling. Does that mean there's a recession?
My local McDonald's closed—that must mean a recession, right?
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Narrator: My fantasy football team is doing so ba... sorry, wrong video.
Are we in a recession? Nobody ever really knows until it's already happened—even economists.
Despite analysts and economists not being definitive about it, there are some tools that can help you analyze the economy to determine if it's expanding or contracting so you can adjust your investing decisions accordingly.
Before we get into these tools, there are a few ways that people define a recession. The one we're going to use says it's "a significant decline in economic activity spread across the economy, lasting more than a few months." That's from the National Bureau of Economic Research, the official arbiter of U.S. recessions. A recession is normally visible in a few areas of the economy, including production, employment, and real income, among others.
Many of these same components make up a country's gross domestic product, or GDP. GDP is the value of all finished goods and services in a country's economy over a certain time frame. It's an economic indicator and if it's rising, that's good. GDP is closely watched because another common definition of a recession is two consecutive quarters of negative GDP growth. Many economists discount this definition because the economy is vast and focusing on GDP alone is too limiting.
There are a few other economic indicators and tools that track recession elements that will help you paint a picture of the economy.
Let's take a look at three of them.
On-screen text: Average weekly hours, manufacturing, unemployment insurance claims, manufacturers' new orders of consumer goods and materials, manufacturers' new orders for nondefense capital goods excluding aircraft, ISM® Index of New Orders, building permits, private housing, S&P 500® index, Leading Credit Index™, interest rate spread (10-year Treasuries minus federal funds rate), average consumer expectations for business conditions.
Narrator: One tool is the Leading Economic Index®, or LEI, from the Conference Board. It tracks 10 different economic indicators, from unemployment metrics to new orders for products and goods. It puts them into a single index that can be used to spot turning points in the business cycle.
Animation: A line chart titled the Leading Economic Index year over year percent change shows the indicator moving up and down in ranging from as high as 15% to as slow as negative 20%.
Narrator: All the data are compiled into one index, which fluctuates depending on those economic factors. This chart shows changes in the LEI line from 1962 to October of 2024. Let's break it down. Focusing on the right, we see the line topped out in 2022 near 12.5%. It fell to around negative 7% in 2023. The gray columns are recessions. If the line falls, the probability of a recession increases, especially when it falls below 0%. If the LEI rises, the probability of a recession decreases.
The LEI tends to be a bit biased toward consumer and capital goods, so that can cause it to misfire. That may have happened in 2023 and 2024, when the LEI signaled another recession. However, one hadn't taken place as of October 2024.
Animation: A matrix of LEI peaks and recessions shows the dates, number of months, and the return of the S&P 500 through the month prior to the recession starting. The lengths and returns vary, with returns ranging from –14.6% to 20.4%.
Narrator: On average, the LEI precedes a recession by 11 months; however, the variation in lead time is as little as three months, like in 1960, and as long as 21 months in 2006. This makes market timing very difficult, but it can still be an insightful tool when used with others.
Animation: A line chart titled the Real-time Sahm Rule recession indicator shows the indicator moving up and down. The line mostly stays between a negative half percent and a positive half percent with occasional spikes of about 2% to 4% and a large spike in 2020 of nearly 10%.
Narrator: One of these other insightful tools is the Sahm Rule Recession Indicator. It tracks the U.S. unemployment rate. Developed by Claudia Sahm, a former Fed economist and White House economic advisor, it monitors the three-month moving average of the unemployment rate. Like the previous chart, the gray columns represent recessions. Notice that the moving average tends to move ahead of a recession. The Sahm rule states that a potential recession signals occurs if the moving average rises by half a percentage point above the lowest level in the last 12 months.
Rising unemployment can snowball as consumers buy less, and companies' profits fall. That's why the Sahm Rule can be a helpful signal for investors analyzing the economic cycle.
Perhaps one of the most talked about recession indicators in the previous decade is the yield curve because of its reliable track record. It's a chart of government bond yields at different maturities—that's the return investors expect to get over the life of the bond. A normal yield curve reflects a higher rate of return the longer your money is tied up—an upward slope from the short-term maturity bonds with lower yields to longer maturities with higher ones. Sometimes the yield curve inverts when shorter maturities are paying higher returns than the longer maturities. When the bond market is out of sync like this, it usually means the Fed's monetary policy is too tight, which tends to precede weakness in the economy.
Animation: A line chart titled Historical yield curve inversions shows the indicator moving up and down ranging from as high as 5% to as slow as approximately negative 4%. Inversions are highlighted any time the line falls below the 0% line.
Narrator: Apart from a brief stint in 1998, inversions have preceded each recession since 1960.
Animation: A matrix of Yield curve inversions and recessions shows the dates, number of months, and the return of the S&P 500 through the month prior to the recession starting. The lengths and returns vary, including returns ranging from –16.6% to 22.8%.
Narrator: On average, an inversion takes place about 13 months prior to a recession. However, like the LEI, it also has had a wide range of lag times, from as low as five months in 1973, to as long as 23 months in 2006.
However, a better recession signal tends to be when an inverted yield curve starts to normalize. One reason for the normalization, or "steepening," as traders call it, is that the Fed sees weakness in the economy and starts to lower interest rates to try and spark economic growth. The lowering of the Fed's overnight rate can cause other short-term interest rates to fall as well. So, yield curve inversions are the "recession watch" signal while the steepening is the "recession warning" signal.
While these indicators can help you potentially better assess the health of the economy, it's important to note that no two recessions are the same. Indicators may trigger because of unique and unexpected circumstances.
Animation: A graph titled Hypothetical sector performance compares the performance of industrial stocks to consumer staple stocks over time and during a recession, showing consumer staples underperforming industrials before and after a recession, while outperforming during the recession.
Narrator: Just like each sector of the economy is affected in different ways, different investments tend to perform better during a recession. So, when it comes to making investing decisions based on whether the economy is in a recession or not, it's important to remember something: The economy and the stock market aren't the same thing. Just because the economy is slowing, it doesn't guarantee that the stock market will fall. And not every bear market means there'll be a recession. That's why maintaining a diversified portfolio of stocks, bonds, and cash investments that reflect your risk tolerance is an important strategy.
Animation: A vertical bar graph titled Average asset performance during recessions (1980-2020) compares the returns of bonds, cash, and U.S. equities. Bonds returned more than 10%, cash close to 5%, and equities had a slight negative return of about 1%.
Narrator: Bonds and cash are seen as defensive asset classes because the principal invested is typically considered to be safer than stocks. On average, they've performed better than stocks during the last six recessions. Bonds have performed the best, returning more than 10% but even cash outperformed stocks. The gains in bonds and cash, help to offset some of the losses in stocks caused by large market swings. Investors who have trouble stomaching those swings sometimes consider reducing their stock investments and increasing bond and cash investments.
Animation: A horizontal bar graph titled Sector performance in periods of contractions compares market sectors. It shows returns of above 10% for consumer staples, about 9% for health care, 3% for consumer discretionary and information technology, a slight negative return for materials, –3% for communication services, –4% for utilities, –5% for energy and industrials, –9% for financials, –13% for real estate.
Narrator: Some active investors may consider increasing their investments in certain stock sectors. Consumer staples, health care, consumer discretionary, and technology have shown strong relative performance to the S&P 500® during recessionary times.
Recessions can be tough on investors because they're often accompanied by market downturns. However, these tools can help you prepare for potential changes in the economy.
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