Is the Stock Market Signaling a Recession Ahead?

Stock investors pummeled by a double-dip downturn since last May are beginning to wonder if the market is trying to tell them something—specifically, whether it is telegraphing an imminent recession. The stock market is a legitimate warning sign. After all, it's a baro­meter of the expectations for the future of corporate America. And indeed, stock market peaks have historically preceded economic downturns by seven to eight months, on average, although the range is much wider.

But as a prognosticator, the market’s record is spotty at best. Stocks have flashed 11 warning signals for the past six recessions, according to global economist Ethan Harris, at Bank of America Merrill Lynch. The market gauges Harris watches recently pointed to a 50% chance of recession—as they did in 2011, when no downturn materialized.

It seems clear, however, that expectations for robust growth are fading. At the end of 2014, Harris was predicting 3% growth in U.S. gross domestic product this year. Last November he lowered his forecast to 2.5%, and now he sees just 2.1% growth, with a 25% chance of recession within the next 12 months (see Kiplinger's GDP forecast).

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There's plenty to worry about. The most recent Purchasing Managers' Index (PMI) showed that manufacturing activity contracted for the fourth straight month. Strength in the dollar is hurting exporters and multinational companies. The most recent employment report showed disappointing payroll growth. And a slowdown in China is sparking worries about a global recession.

But context matters. Manufacturing is just 12% of GDP, and the PMI reading is still above overall recession levels. The dollar’s rise is moderating, and exports, too, play a minor role in GDP. Consumer spending and housing (both healthy) account for roughly 80% of the U.S. economy. The unemployment rate is below 5%. And developments outside the U.S. rarely cause recession here, as the recent eurozone debt crisis shows.

Nor are the usual culprits that typically trigger a recession present in a big way. Rising oil prices? Finding a floor is more the problem these days. Is a market bubble bursting or an industry sector collapsing? Stocks are selling roughly in line with long-term average prices in relation to earnings, and the scale of energy-sector troubles is nothing compared with the financial and housing collapse of a few years ago. Are soaring interest rates choking off growth? Hardly. This time around, a dramatic drop in 10-year Treasury bond yields, to 1.8% in early February, is an ominous sign that investors are worried about the economy.

If anything, the Federal Reserve's extremely accommodative policies, including ultra-low rates, have distorted the view when it comes to spotting the next recession. Moreover, some experts wonder if the Fed has the firepower left to fight one. Investment strategist Jim Paulsen, at Wells Capital Management, would like to see the Fed hike rates more aggressively. "Treating the economy as if it is unhealthy isn't helping anymore," says Paulsen. "Those policies are hurting confidence more than they’re helping fundamentals."

A full-fledged bear market would be another blow to confidence. "If we hit a decline of 25% to 30%, we’ll have a recession," says Leuthold Group chief investment officer Doug Ramsey. Sometimes, he notes, stocks not only lead a recession, they help cause it, too.