When investors closed the book on 2023, many did so with a big smile. The ageless Dow Jones Industrial Average (^DJI 0.95%) firmly put the 2022 bear market in the rearview mirror and galloped to a fresh record high. Meanwhile, the broad-based S&P 500 (^GSPC 1.33%) and growth-inspired Nasdaq Composite (^IXIC 1.59%) respectively gained 24% and 43% for the year.
But a new year brings new opportunities for investors -- and potentially some new concerns.
Image source: Getty Images.
Although there's no such thing as a predictive indicator or economic data point that can, with 100% accuracy, tell investors which direction the Dow Jones, S&P 500, and Nasdaq Composite will move next, there is a select group of forecasting tools and economic metrics that have exceptionally strong historic correlations with moves in the broader market.
One such recession indicator, which hasn't been wrong in 72 years, appears to have a pretty clear message of what happens next for the U.S. economy and stock market.
This recession-forecasting tool has a flawless track record since 1952
Though I've looked at a number of metrics over the past year that have exhibited uncanny correlations to directional moves in the stock market, few have a more extensive track record of predicting the future with accuracy than the ISM Manufacturing New Orders Index.
The ISM Manufacturing New Orders Index is actually a subcomponent of the far more popular ISM Manufacturing Index (also known as the Purchasing Managers' Index, or PMI). The PMI and its subcomponents are based on survey responses from participants and reported monthly.
The ISM Manufacturing New Orders Index examines new order activity within the industrial sector. While technology is playing an increasingly bigger role in U.S. gross domestic product, industrial activity has always been a telltale sign of strength or weakness for the U.S. economy.
This index is measured on a scale of 0 to 100, with 50 serving as the baseline where industrial-order activity is neither increasing nor declining. A reported figure above 50 implies expanding industrial-order activity, while a number below 50 signals industrial-order contraction.
US ISM Manufacturing New Orders Index data by YCharts. Gray areas denote U.S. recessions.
As you can see from the chart above, the ISM Manufacturing New Orders Index came in at a reading of 47.1 for December 2023. Not only does this imply industrial-order contraction for the month, but it marked the 16th consecutive month of a reading below 50.
To build on the above, the PMI has spent 14 straight months in contraction territory (a reading below 50). This ties the length of the contraction associated with the Great Recession and is the second-longest period of sustained manufacturing contraction over the past 75 years. For what it's worth, every time the PMI has reached a streak of at least nine consecutive months of contraction, a U.S. recession has followed.
The ISM Manufacturing New Orders Index has its own line-in-the-sand reading where U.S. recessions have been all but guaranteed. Dating back to the start of 1949, there have been around a dozen instances where the ISM Manufacturing New Orders Index has fallen below a reading of 43.5. One of these instances, which occurred early in 1952, did not lead to a U.S. recession. However, every other instance over the past 72 years where the ISM Manufacturing New Orders Index has dipped below 43.5 has, eventually, been followed by a recession.
Over the previous 16 months, the ISM Manufacturing New Orders Index dipped below this arbitrary level on two separate occasions. If history were to continue repeating, as it has for more than seven decades, the U.S. would be expected to dip into a recession in 2024.
Though the Dow, S&P 500, and Nasdaq Composite aren't tied at the hip to the performance of the U.S. economy, corporate earnings do have a tendency to ebb and flow with the health of the economy. Furthermore, roughly two-thirds of the S&P 500's drawdowns have occurred after, not prior to, an official recession being declared by the National Bureau of Economic Research.
If the ISM Manufacturing New Orders Index is, once again, correct in forecasting a downturn in the U.S. economy, the historic precedent would be for stocks to decline.
Image source: Getty Images.
Perspective is an invaluable tool when investing on Wall Street
At the moment, there are a couple of money-based metrics and recessionary indicators that serve as ominous warnings for the U.S. economy and stock market. However, there's no tool more powerful for investors than their perspective.
For short-term traders, recessions, stock market corrections, and bear markets can create headaches. But for investors with a long-term mindset, history shows that economic downturns and stock market corrections can be blessings in disguise.
As much as investors might dislike recessions, history pretty conclusively shows that they're short lived. In the 78 years following the end of World War II, the U.S. economy has worked its way through 12 recessions. Nine of these 12 downturns resolved in less than a year, with the remaining three lasting no longer than 18 months. Conversely, most periods of economic expansion last for multiple years.
This disparity between good and bad times for the U.S. economy also correlates with the long-term performance of Wall Street's major stock indexes. With the exception of the 2022 bear market, every correction, bear market, and crash throughout history in the Dow Jones, S&P 500, and Nasdaq Composite has eventually been recouped (and some) by a bull market rally.
It's official. A new bull market is confirmed.
-- Bespoke (@bespokeinvest) June 8, 2023
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
To add to the above, the average length of bull markets handily outpaces the typical bear market. In June 2023, researchers at Bespoke Investment Group released a dataset that calculated the average bull and bear market for the S&P 500 dating back to the start of the Great Depression in September 1929. Whereas the average bear market has lasted only 286 calendar days over the past 94 years, the average bull market has stuck around for about 3.5 times as long (1,011 calendar days).
What this data shows is the power of time and perspective. Although we're never going to be able to pinpoint when stock market corrections or bear markets will occur, how long they'll last, or ultimately how steep the decline will be, history conclusively shows that every downturn has been a buying opportunity for the patient investor.
Regardless of what 2024 has in store for investors, those who look to the horizon and exhibit patience are liable to be handsomely rewarded.
