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Are Stocks Going to Crash? This Forecasting Tool Hasn’t Been Wrong in 65 Years, and It Has a Sobering Message for Wall Street

In case you haven’t noticed, the green flag has been waving for optimistic investors for more than a year. Since the start of 2023, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth stock-fueled Nasdaq Composite (NASDAQINDEX: ^IXIC) have respectively gained 18%, 35%, and 56%, as well as pushed to record-closing highs. There’s no denying that a bull market is in full swing.

But unlike bull markets of the past, the current one may not be here for much longer. That’s the message being given to Wall Street from one historically flawless economic forecasting tool.

Image source: Getty Images.

This recession-forecasting tool has never been wrong

To preface this discussion, there is no such thing as a “guarantee” when it comes to predictive indicators and forecasting tools. If there was one, you can rest assured that every professional and retail investor would be relying on it by now.

There are, however, a very small group of indicators that have an uncanny history of strongly (or perfectly) correlating with moves higher or lower in the stock market. The Conference Board Leading Economic Index (LEI) is one such forecasting tool that, through 65 years of history, has an immaculate track record.

The LEI is a 10-component index that’s reported monthly — usually during the third week of the month. Three of its inputs are financial in nature, and include its proprietary Leading Credit Index as well as the returns of the S&P 500 index. The remaining seven inputs are nonfinancial and consist of average weekly initial unemployment claims, the ISM Manufacturing Index of New Orders, and average consumer expectations for business conditions, to name a few.

The goal for the LEI is simple. It’s a “predictive variable that anticipates turning points in the business cycle by around seven months,” according to the Conference Board.

Though increases or declines in the LEI are reported on a trailing-six-month basis, comparing year-over-year and month-over-month trends can often be more valuable for economists and the investing community. As you can see in the post above from market analytics firm Longview Economics, the LEI decreased by 0.3% in March 2024 from the previous month, and has declined in 23 of the last 24 (reported) months.

Historically, a modest decline in the LEI of 0.1% to 3.9% on a year-over-year basis has served as a cautionary tale for Wall Street but doesn’t offer any guidance as to what’s next for the U.S. economy or stock market. However, any time the Conference Board LEI has surpassed a year-over-year decline of 4%, dating back to 1959, the U.S. has not long after fallen into a recession. Currently, the LEI is down more than 5% on a year-over-year basis, as of March 2024.

On the bright side, the magnitude of the year-over-year drop-off is lessening. Nevertheless, there has never been a year-over-year decline of 4% or greater in the LEI dating back more than six decades where the U.S. economy didn’t contract.

Although the Dow Jones, S&P 500, and Nasdaq Composite aren’t tied at the hip to the performance of the U.S. economy, corporate earnings do tend to ebb and flow with the expansion and contraction of the U.S. and global economy. Two-thirds of the S&P 500’s peak-to-trough downturns have occurred after, not prior to, a U.S. recession being declared by the National Bureau of Economic Research (NBER).

In other words, history portends a coming downturn in the U.S. economy, and a potential crash for the stock market.

A businessperson closely reading the financial section of a newspaper.

Image source: Getty Images.

Though stock market headwinds are mounting, perspective is a game-changer for investors

Truth be told, the Conference Board LEI is far from the only predictive tool that serves as a warning for Wall Street right now. A notable decline in U.S. M2 money supply for the first time since the Great Depression, coupled with one of the highest readings for the S&P 500’s Shiller price-to-earnings ratio in 154 years, suggest the Dow, S&P 500, and Nasdaq could be forcibly pushed off their pedestals at any time.

While this may not be what investors want to hear, patience and perspective can change everything.

Although recessions can be scary and result in higher unemployment and temporarily weaker wage growth for workers, they’re ultimately a normal and inevitable part of the economic cycle. More importantly, they don’t last very long.

Since the end of World War II in September 1945, there have been a dozen recessions declared by NBER. Nine of these downturns were resolved in less than 12 months, with none of the remaining three surpassing 18 months.

On the other side of the coin, most economic expansions over the last 78 years and change have extended well past the one-year mark. In fact, two periods of growth stuck around for more than a decade. Taking a step back and understanding the importance of a long-term approach makes these inevitable downturns in the U.S. economy far more manageable.

What’s interesting is that we see this same correlation on Wall Street with the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.

Based on a data set published last year by researchers at Bespoke Investment Group, there have been 27 separate bear and bull markets in the S&P 500 since the start of the Great Depression in September 1929. All told, 13 bull markets have stuck around longer than the lengthiest bear market.

Furthermore, the average S&P 500 bear market has lasted just 286 calendar days over a 94-year stretch. Comparatively, the typical S&P 500 bull market has endured for 1,011 calendar days, or approximately 3.5 times as long.

Though we’re never going to be able to predict with any accuracy precisely when stock market corrections or crashes will occur, how long they’ll last, or how steep the ultimate decline will be, history makes clear that every downturn in the broad-based indexes is eventually (key word!) recouped. If you have the ability to invest for the long run, perspective can be a powerful ally.

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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.

Are Stocks Going to Crash? This Forecasting Tool Hasn’t Been Wrong in 65 Years, and It Has a Sobering Message for Wall Street was originally published by The Motley Fool