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Is it possible to predict the next recession? Let's face it. Everyone wants to know when the next recession will occur. It's only natural.
This question is a primary concern for many economists across the United States who would love to be able to forecast the next recession.
Why? Because at the heart of recession fears lies economic instability.
It's a period marked not just by numbers going south on spreadsheets, but by a palpable sense of uncertainty that permeates all aspects of the economy. Businesses reel under the pressure of falling demand and dwindling profits, often resorting to measures like layoffs or wage cuts.
Prepared investors often find it wise to hire a financial advisor who can assist with developing a sound financial plan, regardless of whether a recession happens or not.
Recessions aren't just a statistic; they can be a human crisis unfolding in real time. Every job loss is a story of a family's struggle, every wage cut a narrative of dreams deferred.
The impact on individual finances during a recession is also significant and cannot be understated. Investment portfolios, often painstakingly built over years, can shrink overnight, leaving even the most prudent savers questioning their financial future.
Since 1956, there have been ten recessions. Many of them, though not all, were preceded by stock market declines as seen in the chart below.
This chart shows the S&P 500 price index with the start of bull and bear markets adjusted to zero. The returns for each period show the relative price returns from the start of the bear or bull market to the end of the market cycle. Bear markets are defined as declines from the prior highest market level that extend beyond -20%. Subsequent bull markets begin from each bear market bottom. Date Range: January 3, 1956 to present. Source: Clearnomics, Standard & Poor's
Conference Board Leading Indicator Index
In the complex world of economic forecasting, the Conference Board Leading Economic Index (LEI) stands out as a crucial tool to help predict recessions.
This index, with its diverse components ranging from manufacturing hours to stock market performance, provides valuable insights into the health and direction of the U.S. economy.
Particularly noteworthy is its year-over-year percent change, which is a key indicator for predicting recessions.
In this article, we'll delve into the intricacies of the LEI and explore how it helps in forecasting economic downturns and potentially, the next recession!
What is the LEI?
The LEI is a composite index that combines ten key economic indicators. These recession leading indicators include:
Average weekly hours in manufacturing.
Average weekly initial claims for unemployment insurance.
Manufacturers' new orders for consumer goods and materials.
ISM Index of new orders.
Manufacturers' new orders for nondefense capital goods excluding aircraft orders.
Building permits for new private housing units.
S&P 500 Index.
Leading Credit Index.
Interest rate spread (10-year Treasury bonds less federal funds rate).
Average consumer expectations for business conditions.
Each of these components provides a unique perspective on the economy's health, combining to offer a comprehensive overview.
Year-over-Year Percent Change: A Key Indicator
The year-over-year percent change in the LEI is particularly important.
This metric helps smooth out monthly volatility and offers a clearer view of the underlying economic trend.
An increasing year-over-year change typically suggests an expanding economy, while a decreasing trend can signal a potential slowdown or recession.
LEI and Recession Prediction
The National Bureau of Economic Research (NBER) defines recessions as a significant decline in economic activity spread across the economy, lasting more than a few months.
The LEI has historically been effective in signaling these downturns.
For instance, significant declines in the LEI have preceded every U.S. recession since the 1970s as illustrated in the recession indicators chart below. Each shaded area represents a recession in the United States.
This chart shows the Conference Board Leading Economic Index (LEI) year-over-year percent change. The index includes: average weekly hours in manufacturing; average weekly initial claims for unemployment insurance; manufacturers' new orders for consumer goods and materials; ISM Index of new orders; manufacturers' new orders for nondefense capital goods excluding aircraft orders; building permits for new private housing units; S&P 500 Index; Leading Credit Index; interest rate spread (10-year Treasury bonds less federal funds rate); average consumer expectations for business conditions. National Bureau of Economic Research Recessions are shaded. Date Range: January 1970 to present. Source: Clearnomics, Conference Board, NBER, Refinitv
This indicator usually turns negative several months before a recession as the economy decelerates.
Notice that we are currently in a substantial year-over-year decline for the LEI indicator.
So, when will the United States enter a recession?
If this recession indicator is correct, it's possible (though not guaranteed) that the United States will enter a recession in the first half of 2024.
Key LEI components like unemployment claims, manufacturing orders, and the interest rate spread are particularly sensitive to economic shifts. An increase in unemployment claims or a decline in manufacturing orders can be early signs of economic distress.
Similarly, a narrowing interest rate spread often indicates tightening financial conditions, which can precede a recession.
What Should You Do to Prepare for a Recession?
For businesses and investors, the LEI can be a wakeup for investors to get their financial house organized.
A declining LEI can signal the need to brace for tougher economic conditions, while an increasing LEI suggests a favorable environment for investment and expansion.
For any of our long-term readers, you know that we do not recommend attempting to time getting in and out of the stock market based on any projection of what may occur in the future.
Why?
A study by Dimensional Fund Advisors looking at data from 1947 to 2022 revealed that the average market returns one year after the onset of a recession were moderately positive, at 6.4%. Three-year and five-year returns were even more robust, with increases of 43.7% and 70.5% respectively over those durations.
Moreover, history has shown that stock markets have bounced back handedly after recessions and, over the long-term, markets have rewarded disciplined investors.
This chart shows the growth of $1 since 1926 in the Standard and Poor's Composite and 10-year U.S. Treasury bonds. Stock returns include dividend reinvestment. The inflation line shows the number of dollars over time to equal $1 in spending in 1926, accoring to the Bureau of Labor Statistics Consumer Price Index. This chart uses a logarithmic scale.
Date Range: January 1926 to present. Source: Clearnomics, Robert Shiller, Standard & Poor's, BLS
But to enjoy the long-term returns that markets provide, it's important that you take the necessary steps to position your investment portfolio accordingly.
So, how can you best prepare for an economic recession?
Build up an adequate cash reserve of 6 to 24 months of expenses.
Consider establishing an equity line of credit (for emergencies only) on your home while you still have reliable income.
Talk to a professional and get a thorough investment portfolio review to analyze the 9 crucial components of well structured portfolio.
A comprehensive portfolio review can help identify your strengths, weaknesses, opportunities and threats.
Moreover, a portfolio review can help you be proactive and potentially restructure your portfolio to focus on the things you can control such as diversifications, costs, risk, taxes, income, and expected returns.
The key is to have a portfolio that is aligned with your goals and has the best chance at weathering an economic recession, whenever that may occur.
Ultimately, we believe that the key to thriving through a recession is to prepare in advance and focus on preparation rather than predicting.
Conclusion
The Conference Board LEI, with its comprehensive blend of economic indicators and its proven track record in recession forecasting, is an indispensable tool for understanding the U.S. economy's trajectory.
Its year-over-year percent change serves as a crucial barometer for assessing the likelihood of an upcoming recession, making it an essential component of any economic analysis toolkit.
While it's impossible to accurately predict recessions all the time, we believe the best course of action is to avoid trying to time the stock market and instead focus on the things you can control.
That starts with analyzing and potentially restructuring your investment portfolio for long-term succcess.
Contact us today for a free assessment where we will provide a thorough review of your financial situation in the areas of retirement, taxes, and your portfolio. After all, the best way to prepare for a recession, is to focus on the factors you can control!
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss.