Unusual developments have intensified the concern. Oil prices have risen to record levels. Home prices have fallen to unprecedented extents. Major political shifts seem inevitable but their nature is still quite unclear.

It would be helpful in these circumstances to find some reliable indicators that provided useful information under diverse conditions in the past. There are indicators with such credentials that cast doubt on the pervasive pessimism.

Real interest rates – which have not been near recession-inducing levels since before the last downturn – have now fallen to levels that spurred economic recoveries and reaccelerations in the past. Unemployment insurance claims – which soar whenever recessions take hold – have still not risen much. The stock market’s valuation relative to interest rates – which tends to rise to extremes before bear markets – remains low. Bearishness – which tends to peak when the stock market troughs – has just reached its highest level since 1990.

These indicators have been reliable over almost five decades. Based on them, pessimism seems less well-founded than feared. A recession seems unlikely, and, if one occurs, it should be mild and short. The stock market has suffered a severe correction but a deeper and more protracted bear market decline seems improbable. Investors should adhere to well-formed asset allocation plans. Stocks should be added if needed to correct portfolio imbalances.

Economic and Market Update: The Continuing Discussion

Investors want to know if a recession will occur because most bear markets in common stock prices start before recessions take hold. There have been exceptions, to be sure. In 1962, the stock market declined in reaction to two major political developments – President Kennedy’s confrontation with the steel industry over price increases and the Cuban Missile Crisis. In 1966, the stock market fell in connection with restrictive economic policies that induced a pronounced economic slowdown that was shallower and shorter than a true recession. In 1987, the stock market “crashed” from an overvalued level. All other major stock market declines anticipated economic downturns. (Figure 1.)

If we could predict recessions, then, we could protect ourselves from most bear market declines in stock prices. But what causes recessions? The best answer is that restrictive Federal Reserve policies cause recessions. And we can tell when the Fed’s policies are restrictive from real interest rates.

Real or inflation-adjusted interest rate levels measure the extent to which the Federal Reserve’s policies are restrictive or not. The federal funds interest rate is the most important rate to watch for this purpose. This is the rate that applies to funds that banks with excess reserves sell to other banks that need them to support their loans and investments. This is also the interest rate that the Federal Reserve raises and lowers to implement its policies. The fed funds rate was lowered to 2.25% in mid-March.

The real fed funds rate is the difference between the nominal interest rate and inflation. The inflation rate used here is based on the Personal Consumption Expenditure Deflator (PCED) – a price index that is similar to but broader and more sensitive to shifts in spending habits than the Consumer Price Index (CPI).

The “core” inflation rate – the 12-month change in the PCED excluding food and energy – is now about 2.0%. Hence, the real fed funds rate is about 0.25% or 25 basis points – the 2.25% nominal fed funds rate minus the 2.9% inflation rate. (Figure 2.)

The reason it is important to know that the real fed funds rate is around 25 basis points is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. The 450 basis point level has been the “tipping point” where the Fed’s policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic decline. Recession risk has been and remains low now because the real fed funds rate has been nowhere near 450 basis points since before the last recession in 2001 (real fed funds’ highest recent level was 334 basis points last summer).

There should be no recession now because the real fed funds rate never approached the level seen before all recessions since 1960. But it also seems important to note that the real fed funds rate has fallen near levels that ended past recessions. This implies that whatever economic weakness exists should prove limited in depth and duration.

But can we be sure that what mattered in the past remains relevant? Could the severe weakness in residential construction or the sharp rise in oil prices pull the economy down into recession despite low real interest rates?

The best answer to this question lies with initial or first-time unemployment insurance claims. Jobless claims soared 20% or more when recessions took hold in the past. So far in the current episode, claims have risen less than 12% above their trailing 12-month low – a rise that is consistent with an economic slowdown but not with a recession.

The fact that jobless claims have not risen more is important evidence that recession fears have been overdone. Unlike almost all other economic data, claims are available almost in real time and are seldom revised much. Since no recession started until after claims soared 20% or more, and since claims have risen less than 12%, the idea that a recession started within recent months seems unfounded. (Figure 3.)  

A recession would pose a serious threat to the stock market but the small rise in jobless claims supports the view that real interest rates are too low to cause one. Absent a recession, stocks tend to rise unless real interest rates soar – which is not an issue now – or unless the market soars and becomes overvalued in the extreme.

The accompanying chart estimates the extent to which the stock market is overvalued or undervalued relative to interest rates. To be somewhat more precise, the earnings yield on the S&P 500 Index is compared to the BAA corporate bond yield, and a fair value for stocks is then estimated from their normalized relationship.

Support for this exercise comes from the fact that it showed the market to be overvalued in the extreme before the 1987 “crash” – and also before many other important market peaks. The stock market is not overvalued in the extreme now and should rise, especially since neither real interest rate levels nor recession poses a serious threat. (Figure 4.)

Economic and market statistics number in the thousands but just a few provide the information that matters most. Real interest rate levels tell us much about the risk that a recession or a bear market could occur. Initial unemployment insurance claims tell us if a material economic slowdown or a recession has taken hold. The relative valuation level tells us if the stock market is vulnerable even when real rates and recession do not threaten.

If one more statistic were permitted, the most useful choice would be the AAII (American Association of Individual Investors) Investor Sentiment Index. This index measures the difference between respondents who are bullish and those who are bearish. To illustrate, if 25% are bullish and 50% are bearish, the difference is -25% – a “net bearish” level. If 50% were bullish and 25% were bearish, the difference would be a “net bullish” +25%.

This sentiment index has been a “contrary” indicator. That is, the more bullish investors are, the worse the stock market tends to perform, and the reverse. In recent weeks, the index has been more bearish than at any time in its 21-year history, except for November 1990, when Desert Storm preparations were underway. Put differently, investors were recently more bearish than after the 1987 crash; after Long Term Capital Management’s collapse in 1998; during the recession, tragedies and financial scandals in 2001-2002; and before the Iraq War. Based on history, such extreme bearishness should turn out to be bullish. (Figure 5.)

Occam’s razor is the principle that the simplest solution is the best. The assessment presented here is simple but not simplistic. Present circumstances are complex but there were many times since 1960 when uncertainties were elevated and threats seemed perilous. And yet the few fundamental indicators discussed here provided useful and reliable clues to economic and stock market trends.

Those few reliable indicators remain more bullish than not.