This Economic Indicator Has Predicted the Last 3 Stock Market Collapses and Recessions

1990, 2001, and 2008. These years all have one thing in common: they are the beginnings of United States recessions of varying magnitude.

The recession of 1990-91 was caused by restrictive monetary policy and agitated by a spike in oil prices. It was the mildest of the three recessions.

In March 2001 the United States officially entered into the next recession, but stock prices had already been falling since the prior September of 2000, precipitated by the epic bursting of the dot-com bubble. Stocks didn't begin to climb again until March of 2003 in what became known as one of the longest bear markets in history. During this time the S&P 500 slowly shed nearly half its value.

We all recall the Great Recession of 2008 along with the terrifying decimation of the real estate market. Just as our retirement accounts were finally beginning to recover to pre-dot-com bubble levels, the housing market decided this would be a great time to belly-flop off the high dive. In the few weeks between September and October of 2008, the market lost 25% of its value. From October 2007 to its lowest point in March 2009, the S&P 500 lost a full 55%. $3.4 Trillion of the market value lost was in retirement accounts. The unemployment rate, loan defaults, and bankruptcies skyrocketed. It's taken our economy years to recover, and some of us will never be the same.

One economic indicator predicted them all. It's called the inverted yield curve.

But First: A Crash Course in Government Bonds

The US Treasury sells government bonds with varying times to maturity. This time to maturity represents the amount of time that an investor has to wait to receive their initial investment in a bond back from the government in addition to any interest payments the investor receives over the life of the bond. For example, an investor who purchases a 10-year bond for $1000 with a coupon rate of 2.5% will receive interest payments of $25 (2.5% of $1000) every year for 10 years, until the initial $1000 is returned on the tenth and final year. Government bonds range in maturity lengths anywhere from 1 month to 30 years.

Government bonds are not just issued by the government and surrendered at the time of maturity. They are also bought and sold on the open market, essentially at any time during the life of the bond. If the stock market is doing very well and bonds are in low demand, bonds will often sell at a discount in order to provide additional incentive for purchasers to buy them. A bond selling at a discount will sell for less than face value, and a bond in demand will sell for a premium.

So this constantly changing value of bonds and their associated yields creates some level of risk, even when those bonds are guaranteed by the full force of the US government. Typically, investors are rewarded with higher yields as the time to maturity of a bond increases. The short-term bond yields are highly correlated to the interest rate set by the Federal Reserve. Longer-term bond yields are more susceptible to change with the winds and tides of the open market - if long-term bonds are in low demand, the bonds will sell at a discount and the resulting yield will be higher. On the other hand, if long-term bonds are in high demand, their purchase becomes more competitive and the yield rates fall.

So What is the Inverted Yield Curve?

The government tracks the yield rates of all the different maturity offerings. For example, the Treasury yield curve as of March 12, 2018, is shown below.

Note in the above plot that the bond yield (y-axis) increases with the maturity length of the bond (x-axis). We have a yield "curve" that is gently sloping upwards and to the right. This is a typical, healthy yield curve.

When Things Go Sideways

The yield curve doesn't always slope gently up and to the right. Sometimes it's flat, and at times it's even been inverted. This can be caused by a combination of many things, but the simplest reason is this: when investors lose confidence in the market and begin to look for other places to keep their money safe for a longer period of time, they will often flock to government bonds. If enough investors begin buying long-term bonds, they become higher in demand and the price to purchase that bond increases. When the purchase price increases, the yield falls. If the yields of long-term bonds fall to a level at or below the yields of short-term bonds, we've reached our perfect storm scenario. As in the yield curve before the Great Recession in November 2006, as shown below. At least that's the theory.

Behold! The pre-recession inverted Treasury yield curve in November 2006!

The federal reserve also publishes a constantly updating graph comparing the 10-year treasury bond yield to the 2-year treasury bond yield. This creates an interesting look at the "strength" of the yield curve over time, plotted against periods of US recession as represented by the grey regions in the graph. When the blue line dips below zero, this is an indication that the yield curve is flat or inverted. Notice the trend of the yield curve going negative before each of the last three recessions!

Can We Predict the Stock Market Too?

Full disclosure: I'm not a huge fan of attempting to time the market. There's plenty of good research out there that shows when people attempt to time the market, they will usually lose. But at the same time, this correlation is difficult to ignore. Below is another look at the correlation between the inverted yield curve and the closing price of the S&P 500. As the dots become redder, the yield curve is more inverted. You may notice a couple things from the graph below:

1) The inverted yield curve, or red-colored dots, predicted a subsequent fall in the stock market in 2000 and 2007.

2) The dark green color, which indicates a healthy yield curve, is beginning to fade in 2017 and 2018 after nearly a decade of strength between 2009 and 2016. We are indeed beginning to approach an inverted yield curve yet again. Especially if the fed continues its plan to raise interest rates.

Mmmkay? So What now?

I, for one, am not willing to completely ignore this signal as a valuable tool. But let's also be realistic - It's also not a surefire harbinger of impending stock market doom. Keep an eye on this indicator. Use it in conjunction with many other indicators to make informed, disciplined decisions. Because if there's one attribute linked to an investor's success over time, it's discipline. And as it turns out, I'm in good company on this belief. The key is to have a gameplan and stick it out. If you have no desire to try and time the market on any number of indicators, make sure you've got a well-diversified portfolio according to your investment horizon, and just ride these turbulent times out. Shameless plug: I made a tool for that on my website.

If you enjoyed this post or maybe even had a little trouble following it, you should sign up for my next investing class in St. Louis . I'll start with the basics and build on investment science fundamentals until you're confident you can invest on your own.

Thanks for reading! Feel free to comment below. What are your favorite economic indicators?