When Recession Indicators Don’t Work Anymore

If Event A preceded Event B 10 out of 10 times in the past, that’s a strong correlation and is worth examining. Whether it’s investable information is a different story entirely. Even the most consistent streaks can be broken, especially during a time of many unprecedented events.

I imagine that very few investors actually go into an all-cash position because they read somewhere that a recession indicator is flashing. After all, many people invest indirectly through their 401(k) and 403(b) retirement accounts, and those accounts are typically always exposed to at least some stocks.

Self-directed investors, on the other hand, can be more nimble and jump in and out of the stock market as they see fit. That’s a double-edged sword, however, as constantly entering and exiting stock positions tends to lead to underperformance. Usually, it’s better in the long run to stay in one’s positions for a while.

But then, you might encounter a chart, video, or social media posting suggesting that a recession is right around the corner. Naturally, an investor wouldn’t want to stay in stocks if an economic meltdown is about to send share prices lower.

That’s when it’s a good time to take a deep breath and refrain from taking any hasty actions. Continue to conduct research on the markets, and let the totality of the data inform your decisions instead of taking action based on a single chart or statistic.

Courtesy: Game of Trades

After all, even the most consistent streaks are often bound to be broken at some point, and rules often have exceptions. This chart provides an excellent example, as a commonly cited recession indicator – an inversion of the 10-year and 2-year Treasury yields – hasn’t always preceded recessions in the U.S.

Granted, the prominent exception to the rule here is from way back in 1965. On the other hand, when yield curve inversions did precede recessions, there was typically a lag between the two events.

In other words, pulling out of stocks completely would sometimes have meant being out of the markets for a year or two, and those may have been strong stock market years. And again, while I’m always wary of anyone who says, “It’s different this time,” it’s hard to deny that the circumstances of the 2020s are unique.

Bear in mind, a yield curve inversion wouldn’t actually cause a recession or a stock market crash. The current fears about an imminent recession are based, for the most part, not on yield curve inversions but on the Federal Reserve raising interest rates for too long and ceasing its bond-buying program.

Those actions could certainly cause a slowdown in the economy, but the Fed can and probably would return to more accommodative actions if economic conditions worsen significantly. To put it another way, the Federal Reserve can flip back from hawkish to dovish at any given moment.

That’s always been the case, but with an election year coming up, the Fed isn’t likely to allow the economy to implode now. Ask yourself: Is it mere happenstance that Federal Reserve Chairman Jerome Powell has stopped talking about an upcoming recession?

Still, you can certainly choose to bet against the stock market if you’re hellbent on doing so. That’s what Michael “Big Short” Burry is apparently doing, as he reportedly just purchased $1.6 billion worth of put options against the SPY ETF (which tracks the S&P 500) and the QQQ ETF (which tracks the NASDAQ).

Courtesy: Financial Times

Or, you can stay calm and carry on, like legendary investor Warren Buffett is evidently doing. He’s building a stake in homebuilders, which is effectively a wager on the strength of the U.S. economy and financial markets.

Of course, for all I know, a recession and a stock market crash could happen in the coming months. Other recession indicators are flashing, such as a downturn in the copper price (that’s why they call it “Dr. Copper”) and the tightening of lending standards, as more restrictive credit conditions generally precede slowdowns in the economy.

Other indicators include the Buffett Indicator, which currently shows that the total stock market is quite high when measured against America’s GDP. But then, as mentioned earlier, Buffett himself is investing now, not hoarding cash.

It’s a strange time in history, really, as investors are willing to “shake off” just about anything nowadays. You can cherry-pick bullish or bearish charts to fit your outlook. Or better yet, you can have no bias at all and just adapt to the situation at hand – as Bruce Lee once put it, “Be like water, my friend.”