Is The Stock Market Predicting A Recession?
Recession risk appears to be rising, according to Wall Street fund managers, analysts and strategists, based on a poll published this week by CNBC. Higher tariffs are cited as the catalyst. For some observers, the sharp drop in the stock market in recent weeks is a smoking gun for expecting that the economy will soon contract.
Equities can be a useful forward-looking indicator for macro conditions, but there are several caveats. One is putting too much faith in one subjective and far from flawless view (in this case via the stock market) for deciding what constitutes a clear recession warning. To minimize bias it’s helpful to model stock market volatility as it relates to historical recession periods with an implied nowcast/forecast of economic contraction. On that basis, using the S&P 500 Index’s drawdown history as a predictor suggests there’s still a low probability that a US recession has started or is imminent.
Let’s start with a review of the S&P’s drawdown, which is currently -7.6% as of Mar. 19, shown in the first chart above. That’s a relatively moderate peak-to-trough slide vs. history, and on its face it doesn’t appear that a recession is in progress or is close to starting.
But eyeballing drawdown vis-à-vis recessions can be tricky. To double-check the signaling for recession risk relative to rolling 1-year S&P 500 changes with a more quantitative approach, a probit model is used, based on business-cycle dates selected by the National Bureau of Economic Research. This model estimates a low probability (roughly 4%) that the US economy is currently in recession, shown in the second chart below.