The world has been holding its breath for about a year now, waiting for a recession that still hasn’t come.
It’s taught us that while it’s easy to call for a recession — and everybody from Wall Street analysts to Cardi B have done so — it’s harder to actually know when one is upon us.
Some people say they know a recession when they see one. Others try to quantify the chances of recession through fancy models and market pricing.
I’m more of a market historian: I study what happened in the past and keep watch on a few different warning signs.
Here are my favorites.
A surge in unemployment claims
It’s hard to have a recession without people losing their jobs. Consumer spending accounts for about 70% of economic output, and many Americans’ primary source of income is from their job. If the economy was a car, the job market would be the engine.
Of course, that makes labor market metrics crucial for gauging how healthy the economy is. Lucky for us, there’s an abundance of jobs data out there, and there’s one specific metric that’s consistently been a red flag for recessions. Typically, a spike in claims for unemployment benefits is the first sign of trouble in an otherwise strong job market. Claims have bottomed an average of 11 months before the past eight recessions, and they’ve often risen substantially right before recessions have started.
Unfortunately, we’ve seen unemployment claims rise over the past several months, from a low of 190,000 in September to about 240,000 now. But while that’s a lot of lost jobs, it pales in comparison to the levels we’ve seen at the start of other recessions. Initial unemployment claims show that just 0.1% of the total labor force has recently lost their jobs — compared to the average of 0.3% at the beginning of recent recessions.
Unemployment claims are moving in the wrong direction, but they’re not at alarming levels (yet). And other job market metrics, like the number of new jobs being added each month, still show a strong undercurrent for employment.
Small stocks fall apart
We often focus a lot on the biggest brands in the stock market — the ones we know well and use in our daily lives. But the smallest stocks tend to give earlier signals if something is going wrong in the economy.
The stock market is a classic leading indicator of the economy, and markets tend to sniff out trouble before it shows up in the data. In the six recessions since 1980, the S&P 500 has peaked an average of three months before the economy has entered a recession. However, the Russell 2000 — a benchmark of small-cap stocks — has peaked before the S&P 500 in five out of six of those cases.
It makes sense, if you think about it. Smaller companies generate more revenue from domestic customers, making them more sensitive to the economy’s ups and downs. Also, they typically have less financial cushion when conditions turn south.
For what it’s worth, the Russell 2000’s last peak was in November 2021, and we’re obviously over a year past that point without a recession taking hold. But small caps did just trail the S&P 500 by the widest margin since 2020 last month, and small business owners are reporting that loans are harder to get now than at any time over the past 10 years. Our biggest concern after March’s banking headlines — tightening credit standards — seems to be materializing.
Maybe our smallest holdings are trying to tell us something.
The yield curve un-inverts
If we’re talking about recession indicators, we need to discuss the yield curve.
Typically, a longer-term bond yields more than a shorter-term note because you naturally assume more risk if you loan your money out for longer periods of time. But these days, investors essentially want a higher payment for lending their money out over a shorter period of time. It’s a bond market phenomenon called a yield curve inversion, and it typically happens when the economy is under stress.
Now, the yield curve has been screaming about a recession for over a year, with two-year yields trading higher than 10-year yields since last April. And investors tuned into the yield curve’s signals are getting fed up.
Here’s the thing. The yield curve is more accurate than precise. It can sense trouble, but not exactly when that trouble will come upon us. In the past six economic cycles, the economy has entered a recession an average of 18 months after the spread between the two-year and 10-year yields first fell negative. In some situations, the yield curve has been inverted for multiple years before a recession started.
And contrary to popular belief, the yield curve has actually un-inverted before the last four recessions, as bond investors have anticipated rate cuts in response to deteriorating economic conditions. We’ve seen the same thing happen this time around, but not to the same extent as before.
I keep an eye on market perception, but I also take it with a grain of salt. At the very least, it’s worth re-examining what you believe about the yield curve before basing your investment decisions on it.
Spotting a recession
Like every other analyst, I have my ways of watching for a recession. But overall, it’s tough for anybody to predict when a recession will come. They’re historically quick and notoriously unpredictable, even if there are trends leading up to them that become obvious in hindsight.
For now, the job market — and those rising unemployment claims —may be the most important piece of data to watch for what happens next. And it never hurts to be a little defensive. Just remember where you can be opportunistic, as well.
*Data sourced through Bloomberg. Can be made available upon request.